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ELEMENTARY PRINCIPLES OF ECONOMICS 



THE MACMILLAN COMPANY 

NEW YORK • BOSTON • CHICAGO 
DALLAS • SAN FRANCISCO 

MACMILLAN & CO., Limited 

LONDON • BOMBAY • CALCUTTA 
MELBOURNE 

THE MACMILLAN CO. OF CANADA, Ltd. 

TORONTO 



ELEMENTARY PRINCIPLES 



OF 



ECONOMICS 






BY 
IRVING FISHER 

PROFESSOR OF POLITICAL ECONOMY 
YALE UNIVERSITY 



THE MACMILLAN COMPANY 
1912 

All rights reserved 



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Copyright, 1910, 1911, 1912, 
By the MACMILLAN COMPANY, 



Set up and electrotyped. Published July, 1912. 



Norboolr ^rtse 

J. S. Gushing Co. — Berwick & Bmith Co. 

Norwood, Mass., U.S.A. 



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Co 

THE MEMORY OF MY FRIEND 

AND COLLEAGUE 

PROFESSOR LESTER W. ZARTMAN 




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PREFACE 

For Teachers 

The words *' Elementary Principles" in the title of this 
book indicate the limits of its scope ; the book is intended 
to be elementary, not advanced, and concerns itself with 
economic principles, not their applications. 

First, being elementary, it does not attempt to unravel 
the most difficult tangles of economic theory or to intro- 
duce controversial matter. For such studies it should be 
succeeded by more extensive treatises {e.g., my own : 'Nature 
of Capital and Income, "^Mathematical Investigations in the 
Theory of Value and Prices, Purchasing Power of Money, 
and Rate of Interest, which follow out the same general 
system of thought and exposition as adopted in this book). 

Secondly, being devoted to principles, the book is con- 
fined to that part or aspect of economics which is now 
coming to be recognized as capable of scientific treatment 
in the sense, for instance, in which that term may be ap- 
plied to physics or biology. The fundamental distinction 
of a scientific principle is that it is always conditional ; its 
form of statement is : // A is true, then B is true. A prin- 
ciple differs in this respect from a fact which asserts 
unconditionally that B is true. Science is primarily con- 
cerned with the formulation of principles. The aim of this 
book is to formulate some of the fundamental principles 
relating to economics. 

The method and order of treatment are not altogether 
traditional. The time-honored order of topics — produc- 
tion, exchange, distribution, consumption — has been found 



VUi PREFACE 

impracticable. Such an order was probably originally in- 
tended to parallel the natural course of events from the 
production of an article to its consumption ; but to-day 
these four topics scarcely retain any traces of such a 
parallelism. "Distribution," for instance, has, in theo- 
retical discussions, long ceased to be a description of the 
processes by which food, clothing, and other goods are 
distributed after being produced and prior to being con- 
sumed, and has become simply a study of the determi- 
nation of rent, interest, and other market magnitudes. 
It is not, therefore, surprising that many other textbooks 
on economics have also broken away from this unfortimate 
order of topics. 

Of the many possible methods of writing economic text- 
books, there are three which follow well-defined, though 
widely different, orders of topics. These are the "his- 
torical," the " logical," and the " pedagogical." The his- 
torical method follows the order provided by economic 
history ; the logical begins with a classification of economics 
in relation to other studies, explains its methodology, 
and then proceeds by means of abstract examples from the 
simplest imaginary case of " Robinson Crusoe economics " 
to the more complex conditions of real life ; the pedagog- 
ical begins with the student's existing experience, theories, 
and prejudices as to economic topics, and proceeds to mold 
them into a correct and self- consistent whole. The order 
of the first method, therefore, is from ancient to modern; 
that of the second, from simple to complex ; and that of 
the third, from familiar to unfamiliar. The third order is 
the one here adopted. That the proper method of study- 
ing geography is to begin with the locality where the pupil 
lives is now well recognized. Without such a beginning 
the effect on the student's mind may be like that betrayed 
by the schoolgirl, who, after a year's study of geography, 
was surprised to learn that her own playground was a part 
of the surface of the earth. In like manner we cannot 



PREFACE IX 

expect to teach economics successfully unless we begin 
with the material already existing in the student's mind. 
Those textbooks which open with a discussion of the rela- 
tions of economics to anthropology, sociology, jurispru- 
dence, natural science, and biology, overlook the fact that 
the beginner in economics is totally unprepared even to 
understand the meaning of these great subjects, much less 
their relations to one another. The same sort of error is 
made by those textbooks which begin with a comparative 
stud)^ of the logical machinery by which truth is ground 
out in economics and in other sciences. The student's 
logical faculty must be exercised before it can profitably 
be analyzed. 

This book, therefore, aims to take due account of those 
ideas with which the student's mind is already furnished, 
and to build on and transform these ideas in a manner 
adapted to the mind containing them. This is especially 
needful where the ideas are apt to be fallacious. The eco- 
nomic ideas most familiar to those first approaching the 
study of economics concern money, — personal pocket 
money and bank accounts, household expenses and in- 
come, the fortunes of the rich. Moreover, these ideas are 
largely fallacious. Therefore, the subject of money is 
introduced early in the book and recurred to continually 
as each new branch of the study is unfolded. For the 
same reason considerable attention is given to cash ac- 
counting, and to those fundamental but neglected princi- 
ples of economics which underlie accounting in general. 
Every student at first is a natural "mercantilist," and 
every teacher has to cope eventually with the prejudices 
and misconceptions which result from this fact. Yet no 
textbook has apparently attempted to meet these difiicul- 
ties at the point where they are first encountered, which is 
at the beginning. 

It may be worth while to distinguish the pedagogical 
procedure here proposed from that recently advocated 



X PREFACE 

under the somewhat infeHcitous title of the "Inductive 
Method." I refer to the method by which the student is 
at first to be taught economic facts without any formula- 
tion of principles. This proposal seems to assume that the 
student's mind is quite a blank to start with, and that it 
is possible on this tabula rasa to inscribe facts without at 
the same time intimating how they are related. The truth 
is, however, that the student's mind is already familiar 
with a great mass of economic facts acquired at home, 
on the street, and from the newspapers. He knows some- 
thing, not only of money and accounts, but of banks, rail- 
ways, retail trade, labor unions, trusts, the stock market, 
speculation, the tariff, poverty, wealth, and innumerable 
other topics. It is equally true that his head is full of 
theories as to the relations of these facts, — the working 
of supply and demand, the nature of money, the operation 
of a protective tariff, etc. The difficulty is that most of 
his theories and many of his supposed facts are false ; and 
before we add to his ill-assorted collection of mental furni- 
ture we must arrange in orderly fashion that which he 
already possesses. Moreover, it is almost impossible to 
impart successfully any considerable mass of disconnected 
facts. If the teacher does not indicate the true connec- 
tions, the student will almost inevitably supply false ones ; 
or else the facts without connections will be also without 
interest. 

These objections to the so-called '' inductive method " 
are not, however, intended as militating against the object 
which its advocates strive to attain, viz., to make the stu- 
dent think for himself, nor against the chief means by 
which they actually attain this object, viz., the use of 
original problems. Every teacher can and should illus- 
trate, emphasize, and elaborate every step in the study of 
principles by propounding problems. Sumner's collection 
of problems, or the more recent collections of Taylor or of 
the University of Chicago, may profitably be used to sup- 



PREFACE XI 

plement those which ever}^ good teacher will readily invent 
for himself from the suggestions of the text, of current 
newspapers, or of students' questions. These should vary 
from year to year according to current events and the 
exigencies of the case as understood by the teacher. 

A pamphlet of suggestions as to problems to be used in 
connection with this book has been prepared for teachers 
and may be obtained of the publishers. It is submitted 
that the present treatment of the subject lends itself pecul- 
iarly to the use of definite soluble problems in place of the 
vague "problems" which are usually employed in economics 
and which call for Httle more than an expression of opinion. 
Incidentally, the teacher will find that these definite 
arithmetical problems are not only much r 3re useful to 
the student, but are much less trouble fr . the instructor 
to correct and grade. 

Problems should, I believe, supplement and not supplant 
a textbook. The effort to substitute problems for textbooks 
has always failed even in those subjects which, Hke algebra 
and geometry, may be said to consist naturally of a series 
of problems. A preKminary framework of general prin- 
ciples is needed in order to formulate special problems of 
real value. Problems which are reall; soluble by the 
beginner can be Httle more than appli:;ations of general 
principles to special cases. 

What has been said will help explain why greater atten- 
tion than usual is here paid to certain themes, such as 
money, bank deposits, accounting, the rate of interest, and 
the personal distribution of wealth ; as well as why less 
attention than usual is paid to certain other themes, such 
as methodology and those obsolete theories like the " wage 
fund " theory which (unlike some other obsolete theories) 
has probably never formed any part of the student's 
mental stock in trade. 

To some critics the abundant use of curves may seem 
too advanced for an elementary work. But their use is 



XU PREFACE 

now so common in the advanced treatises to which the 
student is, if possible, to be led, that their introduction 
here is but a necessary part of his preparation. The very 
fact that there is at present no elementary book in which 
the nature and use of the graphic method has been made 
clear for the elementary student is a strong argument for 
its adoption. Moreover, I am persuaded that the " diffi- 
culties " in the elementary use of curves are largely imagi- 
nary. Every beginner in economics may be assumed to be 
familiar with latitude and longitude on a map, and perhaps 
also with the temperature charts in the daily paper. It is 
a very easy step from these to curves of supply and de- 
mand, provided they be used with sufficient frequency and 
with sufficient system to take lodgment in the student's 
memory. The student who sees but one diagram in a book 
will find the initial effort of understanding that diagram 
scarcely worth while, — not much more worth while than 
to be taught the use of logarithms without applying them 
to more than one or two practical examples. As a matter 
of fact, there are few things which so facilitate the under- 
standing of economic relations at every stage of economic 
study as the use of diagrams ; and it is believed that, with 
them, the elementary student can proceed both faster and 
further in economic analysis than without them. 

Some friends are incHned to criticize the book as being 
too cold an analysis. They point out that the student's 
main interest in the subject is a "human interest" and 
concerned primarily with the practical and immediate 
solution of great public problems. No one acquainted 
with my interest in some of these problems can accuse me 
of lack of appreciation of the "human" element in them all. 
But the more one studies these problems and the attempts 
at their solution, the more evident it becomes that most 
students approach them with an insufficient grounding in 
fundamental principles. In social as in medical therapeu- 
tics a lack of knowledge of anatomy and physiology results in 



PREFACE Xlll 

quackery — in remedies worse than the disease which it 
is proposed to treat. I believe that one of the greatest 
needs to-day in the teaching of elementary economics is 
to curb this popular tendency to run after remedies before 
formulating principles. In the present book, therefore, 
while most of the great practical problems of economics are 
outKned in connection with the principles which must be 
employed in their solution, the solutions themselves are 
not discussed. Full discussion of all these problems is 
impossible in any textbook, and I earnestly deprecate a 
general ex cathedra pronouncement of personal opinion by 
an author on moot questions, especially in a book for imma- 
ture students. The only proper course, in my opinion, 
is for the student first to master the fundamental economic 
principles on which all or most competent economists can 
agree, and then, as suggested on the closing page of this 
book, to take up some one moot question — some burning 
issue of the day — and, so far as possible, master that also. 
In the meantime he should, so far as possible, keep an open 
mind on other problems until, in course of time, they may 
also be taken up intensively, one by one. A textbook 
which attempts to supply the student with ready-made 
opinions on all practical problems "while he waits," may 
be supplying a real demand, but is not performing a high 
service. 

Possibly the slight emphasis here put on historical, de- 
scriptive, and practical economics may decide some teachers 
against the use of this book and lead them to choose a 
book in which "the whole subject of economics" is treated. 
I submit, however, that no such "complete" book exists, 
since no author exists capable of writing it, and that all 
which aim to be complete lack at least half of the subject 
matter here presented and which is taken for granted as if 
fully known by the student. In many books the terms 
"assets," "Liabilities," "income," "cost," and "rapidity 
of circulation" are used without discussion or even definition. 



XIV PREFACE 

It would be out of place here to criticize other textbooks, but 
it 'has been my hope that the present book may be found a 
useful introduction to other books, even those which 
attempt to cover the subject "completely." I -would 
also point out that, by omitting the more "therapeutical" 
parts of the subject, I have escaped most of its controversies, 
for the controversies to-day are more as to the solution of 
practical problems than as to the validity of such elementary 
principles as are contained in this book. Freedom is thus 
allowed to each teacher who uses this textbook to follow 
it up by whichever among others contains the therapeutical 
[treatment which he personally regards as correct. I have 
been struck by the fact that my critics seldom question the 
correctness of the propositions here laid down. If this 
book may afford a common starting point for economic 
instruction of different schools of thought and different 
attitudes toward public problems, it will have served one 
important purpose. 

Especial care has been taken in formulating definitions 
so that the concepts descrn^^ ' '--^ these definitions may 
become firmly fixed in the students' minds. These defini- 
tions and concepts have been chosen in reference to their 
usefulness in economic analysis as well as their conformity 
to practical usage. I am one of those who beKeve that 
when the usage of academic economics conflicts with the 
ordinary usage of business, the latter is generally the better 
Iguide. This is not only because business usage has a 
thousand times the currency of academic usage, but also 
because in general it comes closer to the needs of economic 
analysis. Here is not the place to argue why this is true, 
or even to prove that it is true. I will, however, mention 
lone consideration which appeals increasingly to practical 
teachers : An academic tradition which is unconvincing to 
the student is sure later, when he himself becomes a business 
man and perceives how badly academic traditions are out 
of tune with modern business usage, to breed a deep distrust, 



PREFACE XV 

if not contempt, for all academic economics. Thus, expedi- 
ency, as well as sound theory, should urge teachers to 
respect the usage of business men. 

I have taken so much space to justify those features of 
this book which will seem new, because several teachers to 
whom the experimental editions were submitted have 
condemned it at sight as unteachable. I am glad to re- 
port, however, that the teachers who have actually tested 
the book in classroom have usually become extremely 
enthusiastic over its "teachableness," although many of 
them had begun its use with grave misgivings. 

The experimental editions, of which there were two, 
were made possible by special arrangement with the pub- 
lishers. This gave opportunity for thorough trial for two 
years in classrooms at Yale, under nearly a dozen different 
instructors. As a result of this trial and the many valuable 
suggestions and criticisms which were obtained from 
teachers, students, and friends, the book has been virtually 
written three times. The present — the third and final — 
edition is the first to be offered to the general public. 

I am under obligations to President Hadley of Yale for 
the fundamental idea employed in the discussion of those 
supply curves which illustrate the wilKngness to produce 
"a given amount or more" instead of, as ordinarily assumed, 
*'a given amount or less" ; also for helpful criticism on the 
presentation of that most difficult subject, the rate of 
interest. I am also indebted for helpful criticism to my 
colleagues, Professor Clive Day, Assistant Professors F. R. 
Fairchild, H. P. Fairchild, W. H. Price, and A. L. Bishop, 
Dr. H. G. Brown, Dr. E. J. Clapp, now in New York Univer- 
sity, and Dr. J. L. Leonard; also to Professor Charles W. 
Mixter of the University of Vermont, Professor Harvey A. 
Wooster of De Pauw University, Professor Louis N. Robin- 
son of Swarthmore College, Dean David Kinley of the 
University of Illinois, Professor E. W. Kemmerer of Cornell 
University, Professor H. J. Davenport of the University 



XVI PREFACE 

of Missouri, Professors E. R. A. Seligman, H. R. Seager, 
and H. R. Mussey of Columbia University, R. T. Ely and 
W. A. Scott of Wisconsin University, and W. M. Adriance 
of Princeton University, Mr. W. F. Hickernell, now with 
the Brookmire Economic Chart Company of St. Louis, 
Mr. Morrell W. Gaines of the Statistical Department of 
Brown Brothers and Company of New York, Mr. Julius H. 
Parmelee, statistician of the Bureau of Railway Economics, 
Washington, D.C., Professor E, B. Wilson of the Massa- 
chusetts Institute of Technology, Dr. Leonard Bacon of 
New Haven, and to Mr, J. M. ShortHffe of the Graduate 
Department of Yale University. 

I endeavored to obtain a clear idea of the undergraduates' 
viewpoint by offering prizes for the best criticisms from 
students using the book as a textbook, the prizes being 
awarded by a committee of instructors other than myself. 
In the college year 1 910- 1 911, the students who won the 
prizes were R. H. Gabriel, 1913, E. J. Webster, 1913, and 
G. G. Chandler, 1912, and in the year 1911-1912, Edward 
Click, 1914, W. Van B. Hart, 1914, and M. W. Brush, 1913. 
The criticisms of others besides the prize winners were 
found helpful. To H. Briar Scott, 1913, I am also indebted 
for suggesting the insertion of Figure 2. My greatest 
obhgations for criticism, especially as to the mode of pres- 
entation, are due to my brother, Herbert W. Fisher, who has 
kindly read and criticized all of the original manuscript and 

both preliminary editions. 

IRVING FISHER. 

May, 191 2. 



SUMMARY 



Foundation Stones 
Introduction 
Capital 
Income 
Capital and Income 

Determination of Prices 
General Prices . 
Particular Prices . 
Rate of Interest . 

Principles of Distribution 
Sources of Income 
Ownership of Income . 



Chapters I-II 
Chapter III 
Chapters IV-V 
Chapters VI-VII 

Chapters VIII-XIV 
Chapters XV-XVIII 
Chapters XIX-XXII 

Chapters XXIII-XXIV 
Chapters XXV-XXVI 



CONTENTS BY CHAPTERS 



tHAPTER 
I. 

II. 

III. 

IV. 

V. 

VI. 

VII. 

VIII. 

IX. 
X. 

XI. 

XII. 

XIII. 

XIV. 

XV. 

XVI. 

XVII. 

XVIII. 

XIX. 

XX. 

XXI. 

XXII. 

XXIII. 

XXIV. 

XXV. 

XXVI. 



Wealth i 

Property 23 

Capital .37 

Income 60 

Combining Income Accounts 75 

Capitalizing Income 102 

Variations of Income in Relation to Capital . 127 
Principles Governing the Purchasing Power of 

Money 144 

Influence of Deposit Currency . . . .165 
Causes and Effects of Purchasing Power dur- 
ing Transition Periods 184 

Remote Influences on Prices . . . .192 

Remote Influences (Continued) .... 204 
Operation of Monetary Systems . . . .221 

Conclusions on Money 240 

Supply and Demand 258 

The Influences behind Demand .... 278 

The Influences behind Supply .... 303 

Mutually Related Prices 333 

Interest and Money 354 

Impatience for Income the Basis of Interest . 365 

Influences on Impatience for Income . . . 375 

The Determination of the Rate of Interest . 389 

Income from Capital 410 

Income from Labor 433 

Wealth and Poverty ...... 464 

Wealth and Welfare 494 



CONTENTS BY SECTIONS 



CHAPTER I 

Wealth 

SECTION 

1 . Definition of Economics and of Wealth 

2. Distinction between Money and Wealth 

3. Classification of Wealth 

4. Measurement of Wealth 

5. Price .... 

6. Value .... 

7. Limit of Accuracy in Economic Measurements 



PAGE 
I 

5 

9 

II 

13 

17 
20 



CHAPTER n 
Property 



1 . The Benefits of Wealth .... 

2. The Costs of Wealth .... 

3. Property, the Right to Benefits 

4. The Relation between Wealth and Property 

5 . Table of Typical Property Rights . 

6. Practical Problems of Property 



23 

25 

26 
30 
33 
34 



CHAPTER in 

Capital 

Capital and Income . . . . . . . • 37 

Capital-goods, Capital-value, Capital-balance .... 39 

Book and Market Values ....... 44 

Case of decreasing Capital-balance ...... 45 

Insolvency .......... 48 

Real and Fictitious Persons ....... 50 

Two Methods of Combining Capital Accounts . . . 51 

Ultimate Result of Method of Couples 54 

Confusions to be Avoided 57 

xxi 



XXU CONTENTS BY SECTIONS 

CHAPTER IV 
Income 

SECTION PACK 

1 . Concepts of Income and Outgo ...... 60 

2. Income Accounts ......... 64 

3. Devices for Making Net Income Regular .... 68 

4. How to Credit and Debit ....... 69 

5. Omissions and Errors in Practice .72 

CHAPTER V 
Combining Income Accounts 

1. Methods of " Balances " and " Couples." "Interactions" . 75 

2. Production: Interactions which change the Form of Wealth Tj 

3. Transportation : Interactions which change the Position of 

Wealth 80 

4. Exchange: Interactions which change the Ownership of 

Wealth 81 

5. Accounts Illustrative of Interactions in Production . . 85 

6. Preliminary Results of Combining these Income Accounts . 88 

7. Analogies with Capital Accounting ..... 90 

8. Double Entry in Accounts of Fictitious Persons ... 92 

9. Double Entry in Accounts of Real Persons .... 95 
10. Ultimate Costs and Income ....... 98 

CHAPTER VI 
Capitalizing Income 

1. The Link between Capital and Income .... 102 

2. Capital as Discounted Income ...... 107 

3. The Discount Curve ........ 108 

4. Application to Valuing Instruments and Property . .112 

5. Effect of Changing the Rate of Interest .... 125 

CHAPTER VII 
Variations of Income in Relation to Capital 

1. Interest Accrued and Income Taken Out .... 127 

2. Illustrations . 129 



CONTENTS BY SECTIONS XXlll 

SECTION PAGE 

3. Confusions to be Avoided 132 

4. Standardizing Income . . . . . . . .136 

5. The Risk Element . 138 

6. Review 140 

CHAPTER VIII 
Principles Governing the Purchasing Power of Money 



1. Introductory . . . .... 

2. The Nature of Money ...... 

3. The Equation of Exchange Arithmetically Expressed 

4. The Equation of Exchange Mechanically Expressed 

5. The Equation of Exchange Algebraically Expressed 

6. The " Quantity Theory of Money "... 

CHAPTER IX 

Influence of Deposit Currency 



144 
147 

151 
156 

159 
160 



The Mystery of Circulating Credit . . . . 

The Basis of Circulating Credit . . . . 

Banking Limitations ...... 

The Total Currency and its Circulation . 

Deposit Currency Normally Proportional to Money 

Summary ........ 



i6s 
171 

174 
178 
180 
183 



CHAPTER X 

Causes and Effects of Purchasing Power during 
Transition Periods 

1. Transition Periods 184 

2. How a Rise of Prices Generates a Further Rise . . .186 

3. How a Rise of Prices Culminates in a Crisis .... 187 

4. Completion of the Credit Cycle 189 

CHAPTER XI 
Remote Influences on Prices 

I. Influences which Conditions of Production and Consumption 

Exert on Trade, and therefore on Prices . . . .192 



XXIV CONTENTS BY SECTIONS 

SECTION FAGE 

2. Influences which Conditions Connecting Producers and Con- 

sumers Exert on Trade, and therefore on Prices . -194 

3. Influence of Individual Habits on Velocities of Circulation, and 

therefore on Prices 196 

4. Influence of Systems of Payments on Velocities of Circulation, 

and therefore on Prices . . . . . . '199 

5. Influence of General Causes on Velocities of Circulation, and 

therefore on Prices . . . . . . . .201 

6. Influences on the Volume of Deposit Currency, and therefore 

on Prices 202 

CHAPTER XII 
Remote Influences {Continued') 

1. Influence of "The Balance of Trade" on the Quantity of 

Money, and therefore on Prices 204 

2. Influence of Melting and Minting on the Quantity of Money, 

and therefore on Prices ....... 209 

3. Influence of the Production and Consumption of Money Metals 

on the Quantity of Money, and therefore on Prices . .211 

4. Mechanical Illustration of these Influences .... 215 

CHAPTER XIII 
Operation of Monetary Systems 

1. Gresham's Law ......... 221 

2. Bimetallism 223 

3. When Bimetallism Fails 226 

4. "When Bimetallism Succeeds 230 

5. Changes in Production and Consumption .... 233 

6. The " Limping " Standard 235 

CHAPTER XIV 

Conclusions on Money 

1. Can " Other Things Remain Equal ? " 240 

2. An Increase of Money does not Decrease its Velocity . . 242 

3. An Index Number of Prices 247 

4. The History of Price Levels 253 



CONTENTS BY SECTIONS 



XXV 



CHAPTER XV 

Supply and Demand 

SECTION ■ PAGE 

1. Individual Prices Presuppose a Price Level .... 258 

2. A Market and Competition ....... 260 

3. Demand and Supply Schedules . . . . . .261 

4. Demand and Supply Curves . . . . . . • 263 

5. Shifting of Demand or Supply 268 

CHAPTER XVI 

The Influences behind Demand 

1. Individual Demand Schedules and Curves .... 278 

2. Desirability 281 

3. Illustration .......... 283 

4. Some Remarks on Desirability 286 

5. Individual Demands Derived from Marginal Desirabilities . 287 

6. Relation of Market Price to Desirability 294 

7. Importance of the Marginal Desirability of Money . . . 298 

8. Desires or Wants, the Foundation of Demand . . . 300 



CHAPTER XVII 
The Influences behind Supply 



1. Analogies between Supply and Demand 

2. Principle of Marginal Cost 

3. Upward Supply Curves which Turn Back 

4. Downward Supply Curves 

5. Resulting Cutthroat Competition . 

6. Resulting Tendency toward Monopoly 

7. Fixed and Running Costs 

8. General and Particular Running Costs 

9. Monopoly Price .... 



303 
307 
312 

3H 
317 
321 

323 
326 

329 



CHAPTER XVIII 
Mutually Related Prices 



1 . Arbitrage 

2. Speculation 



333 
338 



XXVI CONTENTS BY SECTIONS 



SECTION 



PAGE 

3. Prices of Goods which Compete on the Demand Side . . 344 

4. Prices of Goods which are Complementary on the Demand Side 347 

5. Similar Relations on the Supply Side 348 

6. Prices of Goods in Series 350 

7. Efforts and Satisfactions the Ultimate Factors . . .351 

CHAPTER XIX 
Interest and Money 

1. The Importance of Interest 354 

2. A Common Money Fallacy ....... 356 

3. Effect during Appreciation or Depreciation .... 359 

4. Effect of Unequal Foresight 362 

CHAPTER XX 
Impatience for Income the Basis of Interest 

1. The Productivity Theory 365 

2. The Socialist Theory 369 

3. Impatience the Source of Interest 371 

CMAPTER XXI 
Influences on Impatience for Income 

1. Differences in Impatience Due to Differences in Human Nature 375 

2. Differences in Impatience Due to Differences in Income. . 378 

3. Influence of the Distribution in Time of the Income-stream 

4. Influence of the Size of the Income-stream 

5. Influence of Uncertainties of Income .... 

6. Summary ......... 



379 
3B1 

383 
386 



CHAPTER XXII 
The Determination of the Rate of Interest 

1. Equalizing Marginal Rates of Impatience by Borrowing and 

Lending 389 

2. Equalizing Marginal Rates of Impatience by Spending and 

Investing 394 



CONTENTS BY SECTIONS 



XXVll 



SECTION 

3. Futility of Prohibiting Interest 

4. Clearing the Loan Market .... 

5. The Conditions Determining the Rate of Interest 

6. Historical Illustrations ..... 

7. Interest and Prices . . . . 

8. Classification of Price Influences . 



PAGE 

400 
404 
406 
408 



CHAPTER XXIII 

Income from Capital 

Distribution according to Agents of Production and according 

to Owners .410 

The Rent of Land ......... 413 

Rent and Interest . . . . . . . . . 422 

Four Forms of Income : Interest, Rent, Dividends, and Profits 423 
Avoidance of Risk 427 



CHAPTER XXIV 



Income from Labor 



1 . Similarity of Rent and Wages 

2. Peculiarities of Labor Supply . 

3. The Demand for Labor . 

4. The Efficiency of Labor . 

5. The " Make-work" Fallacy . 

6. Wages and Enterprisers' Profits 

7. Profits and Distribution Generally 



433 
436 

440 

444 
451 
454 
458 



CHAPTER XXV 



Wealth and Poverty 

1 . The Problems of Wealth and Poverty 

2. National Wealth or Poverty . 

3. Per Capita Wealth or Poverty 

4. Population in Relation to Wealth . 

5. Distribution of Wealth . 

6. Equality of Distribution an Unstable Condition 

7. The Limits of Enrichment and Impoverishment 



464 
467 
469 
472 
476 
478 
483 



XXVlll 



CONTENTS BY SECTIONS 



SECTION PAGE 

8. The Cycle of Wealth 487 

9. The Actual State of Distribution 489 

10. The Inheritance of Property . . . . . .491 

CHAPTER XXVI 
Wealth and Welfare 



1 . True and Market Worth .... 

2. Evils Connected with the Quantity of Wealth 

3. Forms of Wealth Injurious to the Owner 

4. Forms of Wealth Injurious to Society . 

5. Forms of Wealth used for Social Rivalry 

6. The Cost of Vanity .... 

7. Remedies for the Evils of Vanity . 

8. Recapitulation 



494 

495 
498 

499 
500 
506 
508 
511 



ELEMENTARY PRINCIPLES OF ECONOMICS 



CHAPTER I 

WEALTH 

§ I. Definition of Economics and of Wealth 

Economics may be most simply defined as the Science of 
Wealth. It is also known under several other titles, of 
which the most common is " Political Economy." The 
purpose of economics is to treat the nature of wealth ; the 
human wants served by wealth; the satisfaction of those 
wants and the efforts required to satisfy them; the forms 
of the ownership of wealth ; the modes of its accumulation 
and dissipation; the reasons that some people have so 
much of it and others so little ; and the principles that regu- 
late its exchange and the prices which result from exchange. 
In a word, everything which concerns wealth in its general 
sense comes within the scope of economics. It is worth 
emphasizing at the outset, that the chief purpose of eco- 
nomics is to set forth the relations of wealth to human life 
and welfare. It is not, however, within the province of 
economics to study all aspects of human life and welfare, 
but only such as are connected in some rather direct manner 
with wealth. 

To most persons the chief interest in the subject lies in its 
practical applications to public problems, such as those 
connected with the tariff, taxation, currency, trusts, trade- 
unions, strikes, or socialism. These problems suggest that 
something is wrong in the present economic order of society 
and that there is a way to remedy it. But before we can 
treat of economic diseases, we must first understand the 



2 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

economic principles which these public questions involve. 
That is, the study of economic principles must precede the 
application of those principles to problems of public policy. 
In the end the student will reach more satisfactory con- 
clusions, if at the beginning he will put aside all thought 
of such applications, and cease to count himself a free trader 
or a protectionist, an individualist or a socialist, or, indeed, 
any other kind of partisan. 

We must, then, in the first place, distinguish economic 
principles from their applications to public problems ; in 
the second place, we must distinguish those principles from 
their applications to private problems. Economics does 
not concern itself with teaching men how to become rich; 
nor does a practical skill in the art of becoming rich imply, 
necessarily, a sound knowledge of economics. Economics, it 
is true, represents the theory of business ; and business, the 
practice of economics. But, though they are not in the least 
conflicting — indeed, to some extent they are mutually 
helpful — economics and business are nevertheless totally 
different. The primary requisite of a good business man 
is to master the detailed facts which concern his own indi- 
vidual operations ; the primary requisite of a good economist 
is to master the general principles based on business facts. 
Some of the wildest economic theories have originated among 
successful financiers. Men who have been trained in Wall 
Street are often the most sadly lacking in elementary in- 
struction in economics. This is so because the very matters 
with which people have longest been familiar are frequently 
the ones which they have been least disposed to analyze. 
In business theory, no less than in the theory of public 
problems, men take too much for granted. 

Our first rule, then, in approaching the study of economics 
is to take nothing for granted. It is quite as important to 
be careful in defining familiar terms, such as " prices " 
and " wages," as in explaining unfamiliar ones, such as 
" index numbers " and " marginal utility." 



Sec. il WEALTH 3 

The chief purpose of this book is to define clearly the 
fundamental concepts of economics and to state and prove 
the fundamental principles of the science. These concepts 
and principles will then serve as a basis for further study. 
In other books the student will find these concepts and prin- 
ciples applied to problems of public policy, or of business 
management, or of the economic history of nations. We 
are not concerned in this book either with practical prob- 
lems or economic history except as they are used occa- 
sionally to illustrate the principles under consideration. 

Wealth having been designated as the subject matter of 
economics, the question at once arises : What is wealth ? 
By wealth in its broader sense is meant material objects 
owned by human beings. This meaning, however, is broader 
than the ordinary meaning of the term ; for it includes 
human beings themselves. Every human being is a " ma- 
terial object " and is " owned " either by another human 
being, as in the case of slavery, or by himself, if he is a 
freeman. But in ordinary usage men except themselves 
from the category of " wealth " just as, with equal incon- 
sistency, they except themselves from the category of "ani- 
mals." Properly speaking man is wealth, just as, properly 
speaking, man is an animal. But we so seldom need in 
practice to take account of man as wealth that the ordinary 
meaning of wealth includes only material objects owned by 
human beings and external to the owner} In this book we 

1 Every writer may define a term as he pleases, except that he should 
justify his definition in one or both of two ways : (i) by showing that it 
accords with common practice; and (2) by showing that it leads to useful 
results. The above definition of wealth meets both of these requirements. 
It agrees substantially with the usual understanding of business men, and it 
is useful in the development of the science of economics. 

Some economists add to the definition that an object, to be wealth, must 
be useful. But utihty is really implied in ownership. Unless a thing 
is thought to be useful, no one would care to own it. Nothing is owned 
which is not useful in the sense that its owner hopes to receive benefits from 
it, and it is only in this sense that utility is to be employed as a technical 
term in economics. Therefore, as utility is already implied in ownership, it 



4 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

shall follow ordinary usage by employing this narrower 
meaning except occasionally when it will be found conven- 
ient to refer to the broader meaning. Any particular 
article of wealth may be called an " instrument." Thus a 
locomotive is an article of wealth or an instrument. Other 
examples are an automobile, a horse, a house, a lot, a 
chair, a book, a hat, a loaf of bread, a coin. 

In common parlance " wealth " is often opposed to 
" poverty," the contrast being between a large amount of 
wealth and a small amount; precisely as in common par- 
lance " heat " is opposed to " cold," the contrast being 
between a large degree of heat and a small degree. But 
just as in physics ice is regarded as having some degree of 
heat, so in economics a poor man is regarded as having some 
degree of wealth. 

Wealth, then, includes all those parts of the material 
universe that have been appropriated to the uses of man- 
kind. It includes the food we eat, the clothing we wear, the 
dwellings we inhabit, the merchandise we buy and sell, the 
tools, machinery, factories, ships, and railways, by which 
other wealth is manufactured and transported, the land on 
which we Hve and work, and the gold by which we buy and 
sell other wealth. It does not include the sun, moon, or 
stars, for no man owns them. It is confined to this little 

need not be mentioned separate^ in our definition. Other writers, while 
including in their definition the idea of utility, omit the idea of ownership 
and simply define wealth as "useful material objects." But this definition 
includes too many "objects." Rain, wind, clouds, the Gulf Stream, the 
heavenly bodies, especially the sun, from which we derive light, heat, and 
energy, are all useful and material, but are not appropriated, and so are not 
wealth as commonly understood. Even more objectionable are those defi- 
nitions of wealth which omit the qualification that it must be material ; they 
do this in order to include stocks, bonds, and other property rights, as well 
as human and other services. While it is true that property and services 
are inseparable from wealth, and wealth from them, yet they are not them- 
selves wealth. To include wealth, property, and services all under " wealth," 
involves a species of triple counting. A railway, a railway share, and a 
railway trip are not three separate items of wealth ; they are respectively 
wealth, a title to that wealth, and a service of that wealth. 



Sec. 2] WEALTH 5 

planet of ours, and only to certain parts of that ; namely, 
the appropriated sections of its surface and the appropriated 
objects upon that surface. 

§ 2. Distinction between Money and Wealth 

One of the first warnings needed by the beginner is to 
avoid the common confusion of wealth with money. Few 
persons, to be sure, are so naive as to imagine that a million- 
aire is one who has a million dollars of actual money stored 
away ; but, because money is that particular kind of wealth in 
terms of which the value of all other kinds of wealth is meas- 
ured, it is sometimes forgotten that not all wealth is money. 

We are not yet ready for an extended study of money, nor 
even for a definition of money, but as a warning we shall here 
enumerate a few of the most common fallacies which beset 
the subject. The nature of these fallacies the student will 
understand at a later stage. They are introduced here not 
with any idea that the student will at once see where the 
error lies, but chiefly for the purpose of ridding his mind of 
the ordinary unwarranted assumptions about money. 

First among these fallacies, is the assertion that if one 
man " makes money," some one else must " lose " it, since 
there is only a fixed stock of money in the world, and it 
seems clear that " whatever money the money-maker gets 
must come out of some one else's pocket." The flaw in 
this reasoning is the assumption that gains in trade are 
simply gains in actual money, so that in every business 
transaction only one party can be the gainer. If this were 
true, we might as well substitute gambling for business and 
for manufacturing; for in gambling the number of dollars 
won is equal to the number of dollars lost. As a matter 
of fact, however, it is not in order to obtain money that 
people engage in trade, but in order to obtain what money 
will buy, and that is precisely what both parties to a normal 
transaction eventually do obtain. 

\ 

\ 



6 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

Again, some persons have tried to prove that the people of 
the earth can never pay off their debts because these debts 
amount to more than the existing supply of money. " If 
we owe money," it is argued, " we can't pay more money 
than there is." This assertion sounds plausible, but a 
moment's thought will show that the same money can be, 
and in fact is, paid ov€r and over again in discharge of 
several different debts ; not to mention that some debts are 
paid without the use of money at all. 

A few years ago at a meeting of the American Economic 
Association a Western banker expressed the opinion that 
the total amount of money in the world ought to be equiva- 
lent to the total wealth of the world ; else, he suggested, 
people would never be able to pay their debts. He explained 
that in the United States there were twenty dollars of wealth 
for every dollar of money; and he inferred that therefore 
there was but one chance in twenty of a debtor's paying his 
debts. " I will give five dollars," he said, " to any one who 
can disprove that statement." When no one accepted the 
challenge, a wag suggested that it was because there was 
but one chance in twenty of getting the promised five 
dollars ! 

The attempt to equalize money and wealth by increasing 
money twenty fold would, as we shall see later, prove abso- 
lutely futile. The moment we increased the amount of 
money, the money value of all other forms of wealth would 
rise, and there would, therefore, still be a discrepancy be- 
tween the amount of money and the amount of wealth. 

A very persistent money fallacy is the notion that some- 
times th,ere is not enough money to do the world's business, 
and that unless at such times the quantity of money is 
increased, the wheels of business will either stop or slacken 
their pace. The fact is, however, that any quantity of 
money, whether large or small, will do the world's business 
as soon as the level of prices is properly adjusted to that 
quantity. In a recent article on this subject, an editor of a 



Sec. 2] WEALTH 7 

popular magazine put this fallacy into the very title : " There 
is not enough money in the world to do the world's work." 
He says, " The money is not coming out of the ground fast 
enough to meet the new conditions of life." In reality, 
money is coming out of the ground faster than the " new 
conditions " require, with the consequent result of raising 
prices. 

A more subtle form of money fallacy is one which admits 
that money is not identical with wealth, but contends that 
money is an indispensable means of getting wealth. At a 
recent meeting of the American Economic Association a very 
intelligent gentleman asserted that the railways of this 
country could never have been built in the early fifties had 
it not been for the lucky discovery of gold in CaKfornia in 
1849, which provided the " means by which we could pay 
for the construction of the railways." He overlooked the 
fact that the world does not get its wealth by buying it. 
One person may buy from another ; but the world as a 
whole does not buy wealth, for the simple reason that there 
would be no one to buy it from. The world gets its railways, 
not by buying them, but by building them. What provides 
our railways is not the gold mines, but the iron mines. Even 
though there were not a single cent of money in the world, 
it would still be possible to have railways. The gold of 
California enriched those who discovered it, because it en- 
abled them to buy wealth of others ; but it did not provide 
the world with railways any more than Robinson Crusoe's 
discovery of money in the ship provided him with food. If 
money could make the world rich, we should not need to 
wait for gold discoveries. We could make paper money. 
This, in fact, has often been tried. The French people once 
thought they were going to get rich by having the govern- 
ment print unHmited quantities of paper money. Austria, 
Italy, Argentina, Japan, as well as many other countries, 
including the American colonies, and the United States, 
have tried the same experiment with the same results — no 



8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

real increase in wealth, but simply an increase in the amount 
of money to be exchanged for wealth. 

The idea that money is the essence of wealth was one of 
the ideas which gave rise to a set of doctrines and practices, 
called Colbertism or MercantiHsm, the earliest so-called 
" school " of political economy. Colbert was a distinguished 
minister under Louis XIV of France in the seventeenth 
century, and a firm believer in the theory that, in order to 
be wealthy, a nation must have an abundance of money. 
His theory became known as Mercantilism because it re- 
garded trade between nations in the same light in which 
merchants look upon their business — each measuring his 
prosperity by the difference between the amount of money 
he expends and the amount he takes in. To keep money 
within the country, Colbert and the Mercantilists advo- 
cated the policy now known as " protection." 

To-day it is generally understood that, in trade between 
nations, as in that between individuals, both parties may 
gain in an exchange transaction ; but the mercantilistic fal- 
lacy that a nation may get rich by selling more than it pur- 
chases, and collecting the " favorable balance of trade " in 
money, still forms one of the popular bases of protectionism 
in the United States. The more intelligent protectionists 
give quite different reasons for a protective tariff, but the 
old fallacious reason still appeals to the multitude. They 
continue to think that by putting up a high tariff so that 
people are prevented from spending money abroad and are 
compelled to keep it at home, the country will in some way 
be made richer. One reason for the persistence of this 
fallacy is the continued use of the misleading phrase " favor- 
able balance of trade " to indicate an excess of exports over 
imports and " unfavorable balance of trade " to indicate 
the opposite condition. 

Money fallacies of the kinds we have described must be 
carefully avoided by the student. He should realize that 
no technical term, such as " money," can be used as a basis 



Sec. 3l WEALTH 9 

of reasoning without a carefully formulated definition. All 
catch phrases should be avoided. Especially should the 
student be on his guard against every proposition concerning 
money. " Making money," for instance, is a catch phrase 
used without any definition. Properly speaking, nobody 
can " make " money except the man in the mint. The rest 
of us may gain wealth, but, unless we are counterfeiters, we 
cannot Hterally " make " money. 

We live in a complicated civiUzation in which we talk in 
terms of money. Money has come to be a sort of veil which 
liides the other and more important wealth of the world. 
Our first task is to take off the veil and see the wealth under- 
neath. We shall then see clearly that wealth can be accu- 
mulated only as it is actually produced and saved. 

§ 3. Classification of Wealth 

Various kinds of wealth may be distinguished. That 
kind of wealth which consists of portions of the earth's sur- 
face is called land. Among examples of land are to be in- 
cluded not only farms, city lots and streets, but mines, 
quarries, oyster beds, fisheries, waterways, etc. All waters 
which are owned are in economics called land, being a part 
of the surface of the earth. Fixed structures upon land are 
called land improvements. The chief examples of land im- 
provements are houses and other buildings, fences, drains, 
railways, tramways, macadamized streets, etc. Land and 
land improvements taken together are called real estate, the 
word " real " signifying immovable. All wealth which is 
movable may conveniently be called commodities, although 
the usage for this term is not altogether certain. Among 
examples of commodities are wheat, pig iron, food, fuel, fur- 
niture, jewelry, clothing, books, chairs, machinery, etc. 
The term " commodities " also includes slaves, so far as this 
particular species of wealth exists. 

It will be remembered, however, that the definition of 



lO 



ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. I 



wealth which has been adopted excludes free human beings. 
It was in order to exclude free human beings from the cate- 
gory of wealth that the phrase " external to the owner " was 
inserted in the definition. Slaves are wealth, for they are 
external to their owner; but freemen are not wealth in its 
narrower or ordinary meaning.^ 

There are, of course, many admissible ways of classifying 
wealth. That which follows is intended to exhibit the prin- 
cipal groups into which wealth most naturally falls. It is 
advisable that the student construct other classifications for 
himself. 

r Agricultural land 
Land | Building land 

[ Ways of transit 



Wealth 



Real Estate 



Commodities 



Land improve- 
ments 



Raw materials 



Buildings 
Improvements 
on highways 
Miscellaneous 

Mineral 
Agricultural 
. Manufactured 



Finished products I Consumable 
Durable 



^ In the broader meaning of the term "wealth" all men, even freemen, 
are, as has been said, wealth. But they are wealth of a peculiar kind be- 
cause they are not, like ordinary wealth, bought and sold and because the 
wealth owned and its owner are in this case, identical. It is difficult, how- 
ever, to draw a strict line of distinction between slaves (human beings 
owned by other human beings) and freemen (human beings owned by them- 
selves) ; for in some cases human beings are owned partly by others and 
partly by themselves; as, for instance, vassals, serfs, indentured servants, 
long-time apprentices, and men held in peonage. A man bound out to ser- 
vice for thirty years is almost indistinguishable from a slave, and if his 
term of service be long enough, the distinction fades away completely. On 
the other hand, the shorter the term of service the nearer does his condition 
approach freedom. As a matter of fact, almost all workers in modern 
society are bound by contract to some extent and for some period of time, 
even though it be no more than an hour ; and to that extent they are not 
free. In short, there are many degrees of freedom and many degrees of 
slavery, with no fixed line of demarcation. This is one reason why the 
broader meaning of "wealth" is often more useful than the narrower. 



Sec. 4] WEALTH II 

It scarcely needs to be stated that these groups are not 
always absolutely distinct. Like all classes of concrete 
things, they merge imperceptibly into one another. For 
this reason the classification is of importance only as it 
gives a bird's-eye view of the subject matter of eponomics. 

§ 4. Measurement of Wealth 

Having seen what wealth is and what it is not, and having 
classified it roughly, we shall next examine separately its 
two essential attributes, materiality and ownership, deyoting 
the remainder of this chapter to the first of these. . ' 

The materiality of wealth provides a basis for a physical 
measurement of the various articles of wealth. Wealth is 
of many kinds, and each kind has its own appropriate 
unit of measurement. Some kinds of wealth are measured 
by weight. This is true, for instance, of coal, iron, beef, 
and in fact of most " commodities." Of units of weight, 
a great diversity has been handed down to us, such as the 
pound avoirdupois, the kilogram, etc. In England, besides 
the avoirdupois pound, and the Troy pound, there is the 
pound sterling, used for measuring gold coin. This is much 
smaller than any other pound, owing partly to the frequent 
debasements of coinage that have occurred, and partly to 
changes in the past from silver to gold money. In the 
United States a dollar of " standard gold " (gold which is 
2^ fine) is a unit of weight employed for measuring gold 
coin. It is equivalent to 25.8 grains, or to -^q^ of a pound 
avoirdupois, since there are 7000 grains in a pound avoirdu- 
pois. We can scarcely put too much emphasis on the fact 
that the pound sterling and the dollar are units of weight. 
They should be understood as such before any attempt is 
made to understand them as units of " value." 

For many articles it is not so convenient to measure by 
imits of weight as by units of space, whether of volume, of 
area, or of length. Thus we have, for volume, milk meas- 



12 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

ured by the quart, wheat by the bushel, wood by the cord, 
and gas by the cubic foot. For areas, we have lumber 
measured by the square foot, and land by the acre. For 
length, we have rope, wire, ribbons, and cloth measured in 
feet and yards. 

Many articles are already in the form of more or less 
convenient units. In these cases the measure of their 
quantity is the number of such units. For instance, eggs 
or oranges are usually measured by their number, expressed 
in dozens. Similarly, sheets of writing paper are reckoned 
by the " quire," pencils and screws by the " gross." In 
such cases the article is said to be measured " by number." 
But " number " is by no means peculiar to such cases. All 
measurement whatever implies an abstract number, as well 
as a concrete unit. The only peculiarity of so-called measure- 
ment " by number " is that the unit, instead of being one 
which is applied from the outside, as by the yardstick, is 
one into which the things measured happen to be already 
conveniently divided. 

In measuring the quantity of any particular kind of 
wealth it is assumed that the wealth measured is homogene- 
ous, or so nearly so as to admit of measurement by a given 
unit. If different qualities or grades have to be distin- 
guished, the amount of each quality or grade requires sepa- 
rate measurement. A continuous gradation in quality, 
such as is usually found in real estate, makes it necessary to 
distinguish a great number of different qualities. A tract of 
land of TOO acres may consist of a dozen different qualities of 
land, variously adapted to pasture, crops, or other uses. 
To describe all this land as simply so many " acres " is 
misleading. It is necessary to specify separately the num- 
ber of acres of " pasture-land," " wheat-land," etc. 

The unit of measure of any kind of wealth, therefore, 
when fully expressed, implies a description, not only (i) of 
size, but also (2) of quality ; as, for instance, a " pound of 
granulated sugar." It is necessary to enumerate the attri- 



Sec. s] wealth 1 3 

butes of the particular wealth under consideration, or 
enough of these attributes to distinguish that species of 
wealth from others with which it might be confused. 
Thus it is often necessary to specify what " grade " or 
" brand " is meant, as " grade A," " Eagle brand," etc. 
Sometimes the special variety is denoted by a " trademark" 
or " hall-mark." 

Some writers have erroneously supposed that the attri- 
butes of wealth constitute separate and independent " im- 
material " sorts of wealth. But " fertility," for instance, 
is not wealth, though " fertile land " is wealth. " Sweet- 
ness " is not wealth, though "sweet sugar" is wealth; 
" beauty " is not wealth, although a " beautiful gem " or 
other object of art is wealth ; " strength " and " power " 
are not wealth, although "powerful horses," automobiles, or 
waterfalls are wealth.^ / 

§ 5. Price 

We have considered articles of wealth as measured sepa- 
rately. Each kind has its own special unit, as the pound, 
gallon, or yard. But it is convenient also to measure 
the combined value of aggregations of wealth. The term 
" value " introduces the subject of exchange. So much 
mystery has surrounded the term " value " that we cannot 
be too careful to obtain a correct and clear idea of it at the 
outset. In the explanation which follows, the concept of 
value is made to depend on that of price ; that of price, in 
turn, on that of exchange ; and finally, that of exchange on 
that of transfer. In this section we shall treat of price; 

* Some people speak of human qualities — strength, beauty, skill, honesty, 
intelligence, etc. — as though they were wealth. But these bear the same 
relation to human beings as similar qualities of articles of wealth bear to 
those articles; and the only way we can logically make them even attri- 
butes of wealth is, as already stated, to call human beings wealth. Then 
their attributes become attributes of wealth in the broader meaning of that 
term. 



14 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

and, to observe the order of sequence, we must begin with 
transfer. 

Wealth is said to be transferred when it changes owners. 
A transfer is a change of ownership. Such a change does not 
necessarily imply a change of place. Ordinarily, of course, 
the transfer of an article is accompanied by a change in its 
position, the purchase of tea or sugar being accompanied by 
the physical delivery of these articles across the counter 
from dealer to customer ; but in many cases such a change of 
position does not occur, and in the case of real estate it is 
even impossible. 

Transfers may be voluntary or involuntary. Examples of 
involuntary transfers of wealth are : (i) through force and 
fraud of individuals, as in the case of robbery, burglary, or 
embezzlement ; (2) through force of government, as in the 
case of taxes, court fines, and " eminent domain." But 
at present we have to do only with voluntary transfers. 
These are of two kinds : (i) one-sided transfers, i.e., gifts 
and bequests ; and (2) reciprocal transfers, or exchanges, 
wliich are of most importance for economics. An exchange 
of wealth, then, is a pair of mutual and voluntary transfers of 
wealth between two owners, each transfer being in considera- 
tion of the other. 

When a certain quantity of wealth of one kind is ex- 
changed for a certain quantity of wealth of another kind, 
we may divide either of the two quantities by the other and 
obtain what is called the price of the latter. That is, the 
price of wealth of any given kind is the amount of any other 
kind of wealth supposed to be exchanged for one unit of the 
given kind of wealth. Thus if 100 bushels of wheat are ex- 
changed for 75 dollars of gold, the price of the wheat in 
terms of gold is 75 -J- 100, or three-fourths of a dollar of 
gold per bushel of wheat. Contrariwise, the price of gold 
in terms of wheat is 100 -i- 75, or one and one-third bushels 
of wheat per dollar of gold. Thus there are always two 
prices in any exchange. Practically, however, we usually 



Sec. 5] WEALTH 1 5 

speak only of one, viz., the price in terms of money, obtained 
by dividing the number of units of money by the number of 
units of the article exchanged for that money. It follows 
that, practically, the price in money of any particular sort oj 
wealth is the amount of money for which a unit of that wealth 
is exchanged. The fact that wealth is exchangeable and in 
the civiHzed world is constantly changing ownership is of 
great importance for our study. Articles of wealth which 
are seldom exchanged, such as public parks, are not com- 
monly thought of as wealth at all, although logically they 
must be included in that category. 

While it is true that any two kinds of wealth may be 
exchanged, some kinds of wealth are more acceptable in ex- 
change than others. Money primarily means wealth which 
is generally acceptable in exchange. Here for the first time 
we reach a preliminary definition of money. This definition 
is based on the most important characteristic of money — 
its exchangeability. An exchange in which money does not 
figure is called barter. An exchange in which money does 
figure is called a purchase and sale — a purchase for the 
man who parts with the money (or its representative, a 
check), a sale for the man who receives it. Originally, all 
exchange was barter, but to-day most exchange is, as we 
all know, purchase and sale. 

In order that there may be a price, it is not necessary that 
the exchange in question shall actually take place. It 
may be only a contemplated exchange. A real estate agent 
often has an " asking price " ; that is, a price at which he 
tries to sell. This is usually above the price of any actual 
sale which may occur later. In the same way there is often 
a " bidding price," which is usually below the price of actual 
sale. Hence, the price of actual sale usually lies between 
the price first bid and the price first asked. But it sometimes 
happens that the bidder refuses to raise his bidding price, 
and the seller refuses to lower his asking price enough to 
bring the two together. In such a case no sale takes place, 



1 6 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. I 

and the only prices are those bid and asked. For many 
commodities the trade journals report, preferably, prices of 
actual sales; but, where there have been no sales, they 
simply report the prices bid or asked, or both. 

When there is no sale, especially when there is no price bid 
or asked, it is not so easy to answer the question : What is 
the price? Recourse is then had to an " appraisal," which 
is simply a more or less skillful guess as to what price the 
article would or should bring. Appraising or guessing at 
prices is often very difficult. It frequently has to be em- 
ployed, however, by the government, for the purpose of 
assessing taxes and customs duties and condemning land; 
by insurance companies for settling claims and adjusting 
losses ; by merchants for making -up inventories and similar 
statements; and by statisticians for numerous purposes. 
In fact, some people make a living by appraising wealth 
on which, for one purpose or another, a price of some sort 
must be set. The purpose evidently makes a great differ- 
ence in the appraisal. Sometimes we want to know the 
price for which an article could be sold in an immediate 
forced sale ; sometimes, the price it might be expected to 
bring if a reasonable time were allowed; sometimes, the 
price the owner would probably take ; sometimes, the price 
a purchaser would probably give. These prices may all be 
different. A family portrait may be worth a big price to 
the owner, and yet bring next to nothing if sold to strangers. 
The owner would naturally appraise it at a high figure if he 
wished to insure it against fire, but if he should try to bor- 
row money on it from a pawnbroker, the appraisal would 
undoubtedly be low. 

Consequently, in applying an appraisal, we encounter 
many difficulties because the parties involved usually have 
some interest to serve. When a farmer has land for sale, 
he will hold it at a high price to prospective purchasers, 
but will enter it, if the truth must be told, at a low price on 
the tax list. When a fire loss is adjusted, the two conflict- 



Sec. 6] 



WEALTH 



17 



ing interests, viz., the " insured " and the " company," are 
usually represented by two experts, who in case of disagree- y 
ment call in a third. ^ 



§ 6. Value 

Having succeeded in defining the price of any kind of 
wealth, we may next proceed to define the value of any given 
quantity of that wealth. The value of a given quantity oj 
wealth is that quantity multiplied by the price} Arithmetic- 
ally expressed, if the price of wheat is |- of a dollar per bushel, 
then a lot consisting of 3000 bushels would have a value of 
3000 times •§• of a dollar, or 2000 dollars. Algebraically ex- 
pressed, if the price of any good is p and its quantity is Q, 
its value is expressed as pQ. In other words, the value of a 
certain quantity of one kind of wealth at a given price is the 
quantity of some other kind for which it would be exchanged, 
if the whole quantity were exchanged at the price set. 

The distinctions between quantity, price, and value of 
wealth may be illustrated by an inventory such as the fol- 
lowing : — 



Shoes . . . 
Beef . . . . 
Dwelling house 
Wheat . . . 



1000 pairs 
300 lb. 

I house 
100 bu. 



PRICE IN TERMS OF WHEAT 



4j bu. 2 per pair 
\ bu. per pound 
10,000 bu. per house 
I bu. per bushel 



VALUE IN TERMS 
OF WHEAT 



4250 bu. 

60 bu. 

10,000 bu. 

100 bu. 



^ This definition of value departs from the usage of some textbooks, but 
follows closely that of business men and practical statisticians. Economists 
have sometimes confined "price" to what is in this book called money price 
and applied the term "value" to what is here called price. Other econo- 
mists have used the term "price" in the sense of market price — what an 
article actually sells for — and "value" in the sense of appraised price or 
reasonable price — what it ought to sell for. Still others have used the term 
"price" in the sense employed in this book, but "value" in the sense of the 
degree of esteem in which an article is held — what in this book will later be 
called "marginal utility" or "marginal desirability." 

2 "Bushels" refers to bushels of wheat throughout this table. 



l8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

The three columns must be carefully distinguished. 
Only in special cases can any two of the three magnitudes, 
quantity, price, and value, be identical. The table illus- 
trates these special cases. Thus in the last line we find 
quantity and value identical because, in this special case, 
the value of the good is reckoned in terms of itself, — 
wheat in wheat. In the line above, price and value are 
identical because, in this special case, the quantity valued is 
only one unit. The value of one house is the price per 
house. 

The measurement of various items of wealth in respect 
of " value," expressed in terms of a single commodity, such 
as wheat or money, has one great advantage over its meas- 
urement in respect of '^ quantity." This advantage is that 
it enables us to translate many kinds of wealth into 
one kind and thus to add them all together. To add 
up the " quantity " column would be ridiculous, because 
pairs of shoes, pounds of beef, houses, and bushels of 
wheat are unlike quantities. But the items in the last 
column (representing values), being expressed in a single 
common unit (the bushel), may be added together de- 
spite the diversity of the various articles thus valued in 
bushels of wheat. 

Since prices and values are usually expressed in terms of 
money — the most exchangeable kind of wealth — money 
may be said to bring uniformity of measurement out of 
diversity. In other words, it is not only a medium of ex- 
change, but it can be used also as a measure of value. It 
serves as a means of comparing values of different things by 
expressing them both in a common denominator. It would 
be far more trouble to compare each article directly with 
every other article, for there would be many more com- 
parisons. 

Although this reduction to a common measure is a great 
practical convenience, we must not imagine that it gives what 
could in any fair sense be called " the only true measure " 



Sec. 6] WEALTH 1 9 

of wealth. In fact, to measure the amount of wealth by 
its value — i.e., its money value — is often misleading. 
The money value of car wheels exported from the United 
States in one month was $12,000 and in a later month, 
$15,000, from which fact we might infer that the quantity 
of these exports had increased. But the number of car 
wheels exported in the first of those two months was 2200, 
and in the second only 2100, showing a decrease. The 
price had increased faster than the number had decreased. 
Likewise, the figures for imports of coffee in these periods 
show a decline in dollars, despite an increase in pounds. 
Here the price had fallen faster than the number of pounds 
had risen. It is conceivable that the quantity of every 
article might decrease, and yet the price simultaneously 
increase so much that there would be an apparent increase 
of wealth when there really was nothing of the kind. This 
is apt to be the case in times of inflation of the currency. 

Even when we are confessedly trying to measure the value 
of wealth and not its quantity, it is difficult or impossible 
to find a right way. Imports into the United States from 
Mexico in one year were worth twenty-eight millions of 
American gold dollars, and ten years later their value was 
forty millions — an increase in value of forty-two per cent ; 
but these very same imports measured in Mexican silver 
dollars were forty-one millions in the first year and ninety 
millions in the second — an increase in value of nearly one 
hundred and twenty per cent. These two rates of increase, 
although they represent exactly the same facts, do not agree 
with each other; yet the American merchant reckons the 
values one way, and the Mexican merchant, the other. In 
a sense both are right ; that is to say, both are true state- 
ments of the value of the articles imported, one of the 
value in gold and the other of the value in silver. If the 
value were to be measured in iron, copper, coal, cotton, or 
any other article, we should have many other different 
" values," no two of which would necessarily agree. " The 



20 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

value of wealth," therefore, is an incomplete phrase; to be 
definite we should say, " the value of wealth in terms of 
gold," or in terms of some other particular article. Hence 
we cannot employ such values for comparing different 
groups of wealth, except under certain conditions, and to a 
limited degree. To compare the wealth values of distant 
places or times — as America and China, Ancient Rome 
and Modern Italy — will Mevitably give conflicting and 
unsatisfactory results. / 

§ 7. Limit of Accuracy in Economic Measurements 

We have learned how the three magnitudes — quantity, 
price, and value of wealth — are usually measured, and that 
their measurement is practically a very inaccurate affair. 
Yet in the minds of most persons, even of business men, the 
degree of accuracy attainable is exaggerated. Even in the 
measurement of the mere quantities of wealth there are two 
sources of error; for every such measurement includes, as 
we have seen, two elements : a unit and a number or ratio 
(as the pound, and the number of pounds) ; and both the 
unit and the number or ratio may be inaccurate. In 
modern times the first source of error — that of the unit — 
is practically eliminated. Our units of weight and meas- 
ure are standardized by law, and a pound in Cahfornia is, 
for all practical purposes, equal to a pound in Connecticut. 
There is, moreover, at Washington a national bureau and a 
special building for preserving and testing standards of 
measurement. Different towns have their sealers of weights 
and measures, to prevent error through ignorance or fraud. 
Fraud and error still exist, but are much rarer than in 
former times. The Egyptians are said to have been un- 
able to test the accuracy of their units of length closer 
than to I part in 350. The Roman weights were true only 
to I part in 50. And when we go back to primitive units, 
we find that they were very rough indeed. A yard was 



Sec. 7] WEALTH 21 

probably at first the length around the waist, which naturally 
was apt to vary considerably. So also the distance between 
the elbow and the end of the finger was taken as a unit 
and called the ell. Fraud was, therefore, as easy as it was 
common. At Bergen, in Norway, among other relics of 
the old Hanseatic League, are the scales used for buying 
and selling fish, with two sorts of weights used, one con- 
siderably heavier than the other. The heavier were used for 
buying and the lighter for selKng ! Such tampering with 
weights and measures is probably much less frequent to-day, 
although instances of short weights, as in the " sugar trust 
frauds," are often brought to light. 

To-day, therefore, the chief source of error lies not in the 
unit, but in the ratio of the quantity of wealth to that unit. 
In retail trade the inaccuracy from this source is very great. 
If we get our apples or potatoes measured correctly within 
five per cent, we are fortunate. Wholesale transactions 
are more accurate. Probably the greatest degree of accu- 
racy ever attained in commercial measurements is on the 
mint scales employed by the federal government in Phila- 
delphia and San Francisco. These scales weigh accurately 
to within about one part in two million. 

Besides the two sources of error in the measurement of 
mere quantity, when we proceed from quantity to value, 
we introduce still a third source of inaccuracy, viz., the price 
factor by which we multiply the quantity in order to get 
the value. This is especially true if the price be merely 
an " appraised " price. The price in an actual sale is an 
absolute fact and cannot be said to have any inaccuracy; 
but the price at wliich we estimate that a thing would sell 
under certain conditions is always uncertain. In the case of 
" staple " articles, i.e., articles regularly on the market, a 
dealer can often appraise correctly within one per cent. 
Real estate in certain parts of a city where sales are active 
can sometimes be appraised correctly within five or ten per 
cent, but in the " dead " or out-of-the-way parts of some 



22 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I 

towns where sales are infrequent, the appraisement be- 
comes merely a rough guess. Again, in the country districts, 
while farms in the settled parts of Iowa and Texas can be 
appraised within ten or fifteen per cent, in the backward 
parts even an expert's valuation is often proved wrong by 
more than fifty per cent. And where a sale of the article 
in question is scarcely conceivable, an appraisement is almost 
out of the question. To estimate the value of Yellow- 
stone Park is impossible, unless we allow ourselves very 
wide limits of error. ^ 

1 Still wider limits must be allowed when we try to value human beings. 
We can often give a lower limit, but seldom an upper one. The estimates 
may vary enormously with the point of view. It is sometimes said, "If I 
could buy Llr. So-and-so at my valuation and sell him at his, I'd get rich." 

Freemen are seldom appraised at all. When the slaves in the South 
became freemen, they ceased to be appraised as wealth. The result has 
been somewhat confusing to our census statistics. The "Manufacturers' 
Record" of Baltimore recently issued figures showing a sharp drop in the 
assessed valuations of wealth in the South after the war. The inference 
was drawn that the value of wealth had immensely decreased; but a large 
part of this so-called decrease consisted merely in the change of ownership 
of slaves from their old masters to themselves, and their consequent omis- 
sion as items of value. Any valuation of freemen, should exceed that of 
slaves ; but even on the basis of slave values the total value of the human 
beings in any country is always greatly in excess of the total value of all 
other wealth. 



CHAPTER II 

PROPERTY 

§ I. The Benefits of Wealth 

The definition of wealth which has been given restricts 
it to concrete material objects owned by man. Accord- 
ingly, wealth has two essential attributes : materiality 
and ownership. Its materiality was the subject of the 
preceding chapter; its ownership will be the subject of 
the present chapter. 

To own wealth is to have a right to the benefits of wealth, 
and before proceeding further with the discussion of owner- 
ship, we must consider these " benefits " of wealth. To 
own a loaf of bread means nothing more nor less than to have 
the right to benefit by it — i.e., to eat it, sell it, or otherwise 
employ it to satisfy one's desires. To own a suit of clothes 
is to have the right to wear it. To own a carriage is to 
have the right to drive in it or otherwise utilize it as long 
as it lasts. To own a plot of land means to have the right 
to use it forever. The ultimate objects for which wealth 
exists are the benefits which it confers. If some one should 
give you a house on condition that you should never use it, 
sell it, rent it, or give it away, you might be justified in refus- 
ing it as worthless. '^ 

Benefits may also be rendered by free human beings (who, 
according to our broader definition, are included under 
wealth). Such benefits are then usually called services ren- 
dered or work done. When rendered by things rather 
than persons, benefits are commonly called uses. Some- 

23 



24 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. II 

times benefits consist of positive advantages and sometimes 
of the prevention of disadvantages. Benefits, then, mean 
desirable events obtained or undesirable events averted by means 
of wealth or free human beings. For example, when a 
loom changes yarn into cloth, the transformation is a de- 
sirable change due to the loom ; it is a benefit conferred or 
performed by the loom. The benefit from a plow is the 
turning up of the soil. The benefits or services performed 
by a bricklayer consist in the laying of bricks. The benefits 
or uses conferred by a fence around a farm consist in pre- 
venting the cattle from roaming away. The dikes in Hol- 
land confer the benefit of keeping out the ocean. The 
benefits conferred by a diamond necklace consist in its 
pleasing glitter. 

Many articles confer benefits on their owners by yielding 
them money. The benefit to the landlord from the land or 
building which he lets is the receipt by him of rent. The 
benefit to the owners of a railway from the railway is the 
receipt by them of their dividends. But not all benefits, 
of course, are simply the receipt of money. -^ 

To be desirable to the owner, an article must confer bene- 
fits on the owner, but not necessarily on the community 
at large. For instance, the noise of a factory whistle may 
be a nuisance to the community, but as long as it is service- 
able to the owner of the factory, it is for him a benefit. 
Benefits to the owner and benefits to society may be very 
different or may be mutually incompatible. The benefits to 
society are of the greater importance, but, under our present 
system of ownership, the benefits to the owner control the 
prices and values of wealth. In order, therefore, to under- 
stand prices and values as they are actually determined, 
we must fix our attention for the present on the benefits to 
the owner rather than on those to society. / 

Benefits may be measured just as wealth may be measured, 
although the units of measurement are, of course, not the 
same. We measure some benefits by number — as when we 



Sec. 2] PROPERTY 2 5 

count the strokes of a printing press. We measure other 
benefits by time — as when we reckon a laborer's work by 
the number of. hours or days during which he works. Some 
benefits we measure by the quantity of wealth which is pro- 
duced or treated — as when the work of a coal miner is 
measured by the amount of coal he mines, or when the use of 
a loom is measured by the number of yards of cloth it 
weaves, or when the services of a lawn-mowing outfit are 
measured by the number of acres covered. The measure- 
ment of services or benefits is usually rougher than that of 
wealth, because it is more difficult to establish units of 
measure. The shelter of a house or the use or "wear" of a 
suit of clothes is difficult to measure accurately. To save 
trouble, benefits are usually measured by tivie, although, as 
soon as it becomes profitable to do so, the tendency is to 
establish a more satisfactory measure " by the piece." 

When we have measured the benefits of wealth or of free 
human beings, we may apply to them the same concepts of 
transfer, exchange, price, and value, v/hich, in the last chap- 
ter, we applied to wealth. We have seen that wealth may 
be exchanged. The same is true of benefits. In fact, every 
exchange is an exchange of benefits ; for to exchange wealth 
is really to exchange the benefits of wealth, the only object 
in getting wealth being to get its benefits. 

§ 2. The Costs of Wealth 

Opposed to the benefits of wealth are its costs. Costs 
m.ay be called negative benefits. The purpose of wealth is 
to benefit its owner; that is, to cause to happen what he 
desires to happen, and to prevent from happening what he 
desires not to happen. But often wealth can work no 
benefit without entailing some cost, i.e., preventing what is 
desirable or occasioning what is undesirable. For instance, 
one cannot enjoy the benefits of a dwelling without the costs 
of taking care of it, either through the actual labor of clean- i 



26 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 

ing, heating, repairing, and keeping it in order, or the pay- 
ment of money to servants for such purposes ; one cannot 
get the benefit of flour without assuming the cost of knead- 
ing and baking it into bread ; one cannot get the benefit of 
a farm without the cost of tilling it. Whatever wealth brings 
about to the pleasure of the owner is a benefit ; whatever 
it brings about to his displeasure is a cost. He assumes the 
costs only as a means of securing the benefits. Costs are 
thus the necessary evils which must be if we are to, obtain 
the good which wealth affords. -^ 

Like benefits, costs are not only occasioned by wealth, 
but also by free human beings. An employer can 
get benefits from a workman only at the cost of pay- 
ing him wages ; an independent workman can get bene- 
fits from his own exertions only at the cost of liis own 
labor. -/' 

The costs of wealth or of free human beings may, of course, 
be measured, just as benefits are measured — by number, 
by time, or by other appropriate units; and costs when 
thus measured may, by price and value, be translated into 
terms of money precisely like the opposite items — benefits. 
We must beware of assuming that cost is always in the 
form of an expenditure of money. Such money cost has 
received exaggerated importance in the eyes of business 
men and has tended to hide the more important and funda- 
mental kind of cost, namely, labor. Even labor appears to 
the employer in the guise of a money cost — the expenditure 
of wages. This expenditure, however, is not itself labor. 
Those who feel a real labor cost are the laborers themselves. 
It is by their physical and mental exertions that the work 
of the world is cliiefly done. / 

§ 3. Property, the Right to Benefits 

We have said that to own wealth means to have the 
right to its benefits. We have seen what is meant by 



Sec. 3] PROPERTY 27 

" benefits," and shall next examine what is meant by 
" rights." 1 

A property right is the liberty or permit (under the sanc- 
tion and protection of custom and law) to enjoy benefits of 
wealth (in its broader sense) while assuming the costs which 
those benefits entail. The term " property " is merely an 
abbreviation for " property right " or " property rights." 
Just as different kinds of wealth are more or less exchange- 
able, so different kinds of property rights differ greatly in 
exchangeability. Those forms which are most easily and 
commonly exchanged are of most importance for our study. 
Those the exchange of which is infrequent, difficult, or for- 
bidden, are in fact seldom thought of as property rights at 
all, although logically they must be included in that cate- 
gory. In the modern world the right of a parent over a 
child or of a husband over a wife is not by ordinary usage 
called property; for, except in certain renxote corners of 
the earth, their exchange is tabooed. ^ 

It will be observed that property rights, unlike wealth or 
benefits, are not physical objects nor events, but are abstract 
social relations. A property right is not a thing. It is that 
relation of man to things, called ownership. It is in this 
human relationship to wealth that we are most interested, 
and not in the physical objects as such. 

The benefits flowing from wealth require time for their 
occurrence and are therefore either past or future. The past 
and the future are separated by the present, which is a mere 
point of time. The only benefits from wealth which can be 
owned at this present point of time are future benefits. 
Past benefits have vanished. When a man owns any form 
of property, he owns a right to future benefits. The idea of 
" futurity " is, therefore, implied in our definition of property, 
which may, therefore, be more explicitly expressed as follows : 

^ As we have seen that "benefits" may be occasioned not only by wealth 
in its narrow sense, but by free human beings, we shall consider "rights" 
to benefits from both of these sources. 



28 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 

Property is the right to future benefits of wealth {in its broader 
sense). It is also to be observed that the future is always 
uncertain; no man can ever tell in advance exactly how 
much future benefit he can obtain; he can only take the 
chances and risks involved. Consequently, the idea of un- 
certainty is also implied in our definition of property, which 
may, therefore, be still more explicitly expressed as follows : 
Property is the right to the more or less probable future benefits 
of wealth {in its broader sense) . 

If a man has the right to all the benefits which may come 
in the future from a particular article of v/ealth, he is said 
to have its complete ownership, or its ownership without 
encumbrance. If he has a right to only some of the bene- 
fits from a particular article of wealth, he is said to own that 
wealth partially, or to " have an interest " in it. When 
two brothers own a farm equally in partnership, each is a 
part owner ; each has a half interest in the farm ; that is, 
each has a right to half of the benefits to be had from the 
farm. What is divided between the two brothers is not 
the farm, but the benefits of the farm. To emphasize this 
fact, the law describes each brother's share as an " undivided 
half interest." Partnership rights are usually employed only 
when the number of coowners is small. When the number 
is large, the ownership is usually subdivided into shares of 
stock ; but the principle is the same — each individual owns 
a right to a certain fraction of the benefits which come to 
the owners. 

After the quantities of property of different kinds are 
measured, we may apply the same concepts of transfer, 
exchange, price, and value which have already been applied 
to wealth and benefits, each particular kind being measured 
in its own particular unit. Consider, for example, the prop- 
erty called stock in the Pennsylvania Railway Company. 
This is measured by the " number of shares," the share here 
being the unit of measurement. 

It is important that the student should become accus- 



Sec. 3] PROPERTY 29 

tomed to see the real basis underlying property rights. This 
basis is either wealth or free persons, or both. Practically it 
is usually wealth. A mortgage is based on land, and great 
care is taken not to have the mortgage too large for the basis 
on which it rests. Railroad stocks and bonds are based on 
the real railway. Personal notes are based partly on the 
person issuing them and partly on his wealth. A street 
railway franchise is a property right, the physical basis of 
which consists in the streets. Sometimes the property 
rights are removed several steps from the real basis. If a 
number of factories are combined into a " trust," the origi- 
nal stockholders surrender their stock certificates to trustees 
and receive in their place trust certificates. Their rights are 
then a claim against the trustees who hold the stock which 
represents the factories. The ultimate basis for their rights 
is still the factories, but their ownership is indirect. 

The future benefits fl.owing from wealth may be compared 
to a pennant attached to a flagstaff — a long streamer 
stretching out into, the future. Two of the possible ways 
in which the present ownership of these benefits may be sub- 
divided are indicated in Fig. i. Here are two " streamers " 
representing the streams of benefits which may come from 
a dwelling house. These begin at the present and stretch 
out indefinitely into the future. If two brothers own the 
house in partnership, each has a right to half the shelter 
of the house, i.e., to half of its benefits; the benefits are 
therefore divided, so to speak, longitudinally in time. 

But if the house is rented, the division of benefits between 
the tenant and the landlord is transverse, as shown in the 
lower " streamer " of the diagram. The tenant has all the 
shelter of the house until the time when his lease is to expire, 
while the right to all shelter beyond the time of the lease 
rests in the landlord, either to use himself or to sell to 
others by new leases. 

These are not, of course, the only ways in which future 
benefits may be parceled out among their several owners, 



A'S SHARE OF FUTURE BENEFITS 



Teman.ts 

SHARE 



Landlord's 

SHARE 



30 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 

but they are the principal and usual modes of sub- 
division. 

In common speech, the minor rights to wealth are not 
ordinarily dignified as rights of ownership. Thus a tenant's 

right in the dwelling 

Bs SHARE OF FUTURE benefits"? ^6 occupies is sharply 

distinguished from the 
right of the owner. 
Yet, strictly speaking, 
every right to the 
benefits of wealth or 
to the services of free 
human beings, how- 
ever insignificant that 
right may be, is a part 
ownership. When an 
owner of land wishes 
to give an unencum- 
bered title, he finds it necessary to extinguish all out- 
standing leases, or claims for future benefits, often at 
considerable cost. It is the total ownership which he is 
selling, and the total ownership always includes the owner- 
ship which the tenant enjoys. Thus the tenant of a 
dwelling is, to a very slight extent, a part owner of that 
dwelling. In the same way the employer is, to a very 
slight extent, a part owner of the employee. 

§ 4. The Relation between Wealth and Property 

We have thus far considered three very important and 
fundamental concepts: wealth, benefits, and property. A 
convenient collective term for all of them is " goods." 

Wealth and property are only present representatives of 
future benefits and future costs. Wealth (in its broader 
sense) is the present means by which we secure future bene- 
fits ; while property is the present right to these benefits. 



Present 

INSTANT 

Fig. I. 



Sec. 4] PROPERTY 31 

and so to the wealth (in its broader sense) which yields 
them. It follows that wealth (in its broader sense) on 
the one hand, and property rights on the other, may be 
said to correspond to one another. The wealth (including 
free human beings) consists in real tangible things, while 
the property rights represent intangible, abstract relations 
which persons, as owners, hold toward them (the wealth, 
including free human beings). Wealth and persons are 
the important things; property is the human right of 
ownership of the wealth or of the services of free 
human beings. In specific cases we can readily see the 
correspondence between the wealth and its ownership. 
In fact, in cases where wealth is owned unencumbered 
or completely, the correspondence is altogether too ob- 
vious; so obvious that in ordinary parlance the two 
terms, " wealth " and '' property," become confused, as 
when speaking of a piece of wealth, in the/form, say, of 
land, we call it a " piece of property." / 

On the other hand, where the ownership is minutely 
subdivided, the wealth and the property rights to that 
wealth become so dissociated in our minds that we are apt 
to fall into the opposite error, and entirely lose sight of 
their connection. For instance, when railway shares are 
sold in Wall Street, the investor rarely thinks of those shares 
as connected with any actual wealth. All that he sees are 
the engraved certificates of his property rights; he has no 
visual picture of the railway. Sometimes the rights are so 
far separated from the thing to which the rights relate, that 
people are unaware that there is anything behind the rights 
at all, and delude themselves with the notion that there 
need not be anything behind them. A government bond, for 
instance, is often regarded as a kind of property behind which 
there is no wealth. But if we examine the case, we shall 
find that the wealth of the entire community is behind 
this property right ; for it is by means of the taxing power 
that the bonds are to be paid, and this taxing power can 



32 ELEMENTARY PRINCIPLES OF ECONOMICS [ChAP. II 

only be effective by means of wealth (including freemen) 
as sources of income. For cities, in fact, this is definitely 
recognized; there is usually a legal debt limit expressed 
in terms of the value of taxable wealth, to insure the 
creditors that there shall always be sufficient real wealth 
behind the city bonds to make their ultimate payment 
secure. 

Not only should the student clearly distinguish in his 
mind between the three important concepts, wealth (in- 
cluding man), benefits and property, but he should avoid 
confusing any of these with a fourth relatively unimpor- 
tant concept, nam.ely, certificates of ownership. To avoid 
misunderstanding, it is often necessary that property rights 
should be evidenced by written documents. Examples of 
such written evidence or certification of property rights are 
deeds for real estate, receipted bills for goods bought and paid 
for, engraved stock certificates, railway tickets, signed prom- 
issory notes, v/ritten contracts with laborers to "work out" 
a sum of money advanced, etc. It is clear, however, that 
such written e\ddence of property rights is very different 
from the property rights themselves; and in many cases 
such rights exist without any written evidence. Thus, the 
farmer who rears his own cattle, or horses, or sheep, usually 
has no written evidence of property rights in them. Or, 
two brothers might own and operate a farm in partnership, 
without any written evidence as to their partnership rights, 
i.e., their respective rights in the products of the farm. Or, 
again, one person might, without written evidence, lease 
(say) a cottage for a season from a friend. In all these 
cases, there are no documentary evidences of property 
rights. Yet in all three cases property rights exist. In 
the first case the right is complete ; in the other two cases 
partial, the benefits being subdivided, — in one case lon- 
gitudinally, in the other, transversely. 



Sec. 5] 



PROPERTY 



33 



§ 5. Table of Typical Property Rights 

The following table indicates the most important t5rpes of 
property, and shows in each case the wealth on which the 
property right is based and the benefits accruing from that 
wealth. The most important forms are : unencumbered, 
stocks, bonds, notes, leases, and partnership rights. 



TYPICAL CASES ILLUSTRATING THE EXISTENCE OF 
WEALTH BEHIND PROPERTY RIGHTS 



[Name of Case 


Wealth on which 
THE Property 
Right is Based 


Beneeits of 
that Wealth 


Description op 
Property Right 


Certificate 

OF Ownership, 

IF Any 


Unencumbered 


Farm 


Yielding crops 


Right to all use 
of farm for- 
ever 


Deed 


Partnership 


Dry goods 


Yielding profits 


One partner's 


Articles of 






from sale 


" undivided " 
fractional in- 
terest 


agreement 


Joint Stock 


Railway 


Yielding profits 


The shares of 
stock 


Stock certifi- 
cate 


Street Franchise 


Street 


Use of same for 
passage, etc. 


Right to run 
cars through 
it 

Right of tenant 


Charter 


Lease or Eire 


Dwelling 


Use of same for 


Lease 






shelter, etc. 


till fixed date 




Railway Ticket 


Railway 


Transportation 


Right to speci- 
fied trip 


Ticket 


Railway Bond 


Railway 


Payment of " in- 


Right to same 


Bond certifi- 






terest " and 


and contin- 


cate 






" principal " 


gent right to 
foreclose 




Personal Note 


All the posses- 
sions of the 
signer 


Payments 


Right to same 
and in de- 
fault thereof, 
right to collat- 
eral security 


Note 


Work due from 


Workmen 


Work 


Right of employ- 


Written con- 


Contract Labor 






er to perform- 
ance of same 


tract 



34 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 



§ 6. Practical Problems of Property 

We have seen that wealth (including man), on the one 
hand, and property rights, on the other, correspond to each 
other. When we treat of the welfare of a community, we 
think rather of wealth (in its broader sense) than of prop- 
erty. When we treat of the welfare of an individual, we 
think rather of property than of wealth. This fact of corre- 
spondence between property rights, on the one hand, and 
wealth (including man), on the other, should be empha- 
sized, because it will save us from confusions which are all 
too common, and it will save us also from many practical 
blunders growing out of these confusions. If our State 
legislators understood this, there would be less of the 
iniquitous double taxation that is the bane of the present 
systems of State and local taxation. Such unjust taxation 
is illustrated by the case of the Massachusetts factory owner 
who decided to transfer his property to a stock company of 
which he himself should hold all the stock. Previously he 
paid taxes only on the factory itself ; but when the " com- 
pany" was formed (under a Maine charter), the tax collector 
came along and informed him that henceforth not only 
must the " company " pay taxes on the factory, but that 
he personally must pay taxes on the stock also, since stock 
in a Maine company is taxable " personal property." 
Thus the owner was taxed both on the stock which repre- 
sented the factory and on the factory itself. Instances 
of double taxation are quite common in the United States, 
though they are not all so self-evident as this. It is not 
within the scope of this book to discuss taxation or other 
practical problems of economics. The object of this 
section is merely to point out what practical problems are 
related to " property." 

Many of the most important problems of economic 
policy are problems of the form of ownership of wealth. 



Sec. 6] PROPERTY 35 

The great question of slavery, for instance, turned upon the 
question whether one man should be owned by another, ^z 

A more modern problem of property is that of perpetual 
franchises. Is it, for instance, good public policy to grant to 
a street railway company in perpetuity the right to use a 
city's streets? Or ought we to fix a time limit, say fifty 
years, after which the right shall revert to the city? A 
kindred question has been raised as to private property in 
land. Is it wise public policy that the present form of land 
ownership in fee simple should continue? Ought a man 
to have the right to a piece of land forever, perhaps abus- 
ing that right, obstructing others, and neglecting the oppor- 
tunities which it affords; or should the government own 
the land and lease it to individuals for limited periods? 
This question is now being discussed with reference to our 
mineral lands, and particularly our coal lands in Alaska. 
Questions of land ownership have in all ages vexed men's 
minds and been the source of social unrest. Rome had 
her agrarian troubles, not unUke those of modern England 
and Ireland. 

The right to bequeath property is also a prime source of 
trouble. This right to dispose of property by will has not 
always been recognized. It was developed by the Romans, 
from whose system of law we borrowed it. Even now it 
is a limited right, and its exercise differs with law and custom. 
These differences are responsible for peasant proprietorship 
in France and for primogeniture in England. The right has, 
indeed, been limited so as to prevent the perpetual tying-up 
of an estate by a testator. Its further limitation will prob- 
ably be one of the problems of the future. 

An even broader question of the same sort is the question 
of socialism. Shall we discontinue what is called private 
property, except in the things that we wear and eat, and pos- 
sibly the houses in which we live? That is, shall we allow 
our railways and our factories to be owned by private indi- 
viduals? Or shall they be owned by the community at 



36 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. II 

large so that we may all have shares in them, as we already 
have in the post ofl5.ce and the government printing office ? 
These are some of the greatest problems in economics; 
and they are problems concerning the ownership of wealth. 
The answers to these questions do not come within the pur- 
pose of this book, which is concerned merely with principles. 
The problems are mentioned, however, as illustrating the 
application of principles here discussed. 



■i. 



CHAPTER III 

CAPITAL 

§ I. Capital and Income 

In the foregoing chapters we have set forth several funda- 
mental concepts of economics — wealth, property, benefits, 
price, and value. We have seen that wealth in its broader 
sense includes human beings, and that property in its 
broader sense includes all rights whatsoever ; that benefits 
are the desirable occurrences which happen through wealth 
(in its broader sense) ; that prices are the ratios of exchange 
between quantities of goods of various kinds (wealth, 
property, or benefits) ; and that value is price multiplied 
by quantity. These concepts are the chief tools needed in 
economic study. 

Little has yet been said about the relation of these 
various magnitudes to time. When we speak of a certain 
quantity of wealth, benefits, or property, we may refer either 
(i) to a quantity existing at a particular instant of time, or 
(2) to a quantity produced, exchanged, transported, or con- 
sumed during a particular period' oi time. The first is a 
stock of " goods " ; the second is 2i flow of '' goods." Ex- 
amples of stocks are the stock in trade of a merchant on 
a certain date, the cargo of wheat on board a ship, the 
amount of food in a pantry at a particular instant, the 
number of shares of stock owned by a particular individual 
in a particular corporation at a particular date. Examples 
of flows are the sales of merchandise made in the course of 
a given month by a given merchant, the amount of wheat 

37 



38 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

imported into a given country during a given year, the 
quantity of food consumed by a family in a given week, 
the sales of a given kind of stock on the New York Stock 
Exchange during a given number of days, the transporta- 
tion accomplished by a railway in the course of a certain 
year, the work done by a given man in a given time. 

The most important purpose of the distinction between a 
stock and a flow is to differentiate between capital and income. 
Capital is a stock, and income a flow. This, however, is not 
the only difference between capital and income. There is 
another, equally important ; namely, that capital consists 
of wealth, while income consists of benefits. We have, 
therefore, the following definitions : A stock of wealth existing 
at a given instant of time is called capital ; a flow of benefits 
from wealth through a period of time is called income. 
Many authors restrict the name capital to a particular 
kind or species of wealth, or to wealth used for a particular 
purpose, such as the production of new wealth ; in short, to 
some specific part of wealth instead of any or all of it. 
Such a limitation, however, is not only difficult to make, 
but cripples the usefulness of the concept in economic 
analysis.^ 

A dwelling house is capital ; the shelter or the rent it 
affords, during any given period of time, is income. The 
railways of the country are capital ; their benefits (in the 
form of transportation or its equivalent in dividends) are 
the income they yield. 

The term capital is also applied to a stock or fund 
of property existing at an instant of time. But such 
" capital property " is not, of course, in addition to ''cap- 

^ Just as wealth may be considered in a broader sense as including 
freemen, so capital may also be considered in this broader sense. Thus 
an individual, because of his ability to work, may be considered as capital, 
while the benefits resulting from his labor (services rendered employer or 
self) should be considered as income. However, in the following dis- 
cussion of " capital," we shall, except where the contrary is expressly 
stated, use the term in its narrower sense. 



Sec. 2] CAPITAL 39 

ital wealth," but merely instead of it ; for we have seen 
that wealth and property are coextensive. The only 
true capital of .society as a whole is its capital- wealth, — 
its lands, railways, factories, dwellings, and in its broader 
sense its human inhabitants also ; but since the owner- 
ship of many of these things is subdivided, the capital 
of an individual can often be stated only in terms of 
property — his stocks, bonds, mortgages, personal notes, etc. 

/ 
§ 2. Capital-goods, Capital-value, Capital-balance 

We have defined capital as a stock of wealth existing 
at a given point of time. An instantaneous photograph of 
wealth would reveal, not only a stock of durable wealth, 
but also a stock of wealth more rapid in consumption. 
It would disclose, not the annual procession of such wealth, 
but the members of that procession that had not yet passed 
off the stage of existence, however swiftly they might be 
moving across it. It would show trainloads of meat, eggs, 
and milk in transit, as well as the contents of private store- 
rooms, ice chests, and wine cellars. Even the supplies on 
the table of a man bolting his dinner would find a place. 
So the clothes in one's wardrobe, or on one's back, the 
tobacco in a smoker's pouch or pipe, the oil in the can or 
lamp, would all be elements in this flashlight picture. 

We have seen in the last two chapters that wealth and 
property may be measured either by quantities (such as so 
many bushels or pounds or so many shares or bonds of a 
particular description) or by value (such as so many dollars' 
worth) . When a given collection of capital is measured in 
terms of the quantities of the various goods of which it is 
composed, it is called capital-wealth or capital-property or, 
to include either, capital-goods; when it is measured in 
terms of its value, it is sometimes called capital-value. 

One of the best methods of understanding the nature of 
capital is to understand the method of keeping capital ac- ^ 



40 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

counts. We shall, therefore, in the remainder of this chapter 
indicate some of the principles of capital accounting. Such 
a study is useful not only because it enables us to keep our 
own capital accounts and to understand the accounts of 
banks, railways, and other institutions as published, but, 
what is more important for our present purpose, because 
it shows how in the present compHcated world of divided 
ownership of capital, with its interrelated arrangement of 
stocks, bonds, debts, and credits, the capitals of individuals 
dovetail into one another, forming together the capital of 
the community. 

A capital account or balance sheet is a statement of the 
quantity and value of the wealth of a specific owner at any 
instant of time. It consists of two columns — the assets and 
the liabilities — the positive and negative items of his capital. 
The liabilities of an owner are his debts and obHgations to 
others ; that is, they are the property rights of others for 
which this owner is responsible. The assets or resources of 
the owner include all his capital, irrespective of his Uabilities. 
These assets include both the capital which makes good 
the liabilities, and that, if any, in excess of the liabihties. 

The owner may be either a physical human being or an 
abstract entity called a " fictitious person " made up of a 
collection of human beings and keeping a balance sheet 
distinct from, those of the individuals composing it. Ex- 
amples of fictitious persons are an association, a partner- 
ship, a joint stock company, a government. With respect 
to a debt or liability, the person who owes it is the debtor, 
and the person owed is the creditor. The difference in 
value between the total assets and the total liabilities in 
any capital account is called the net capital, or capital- 
balance of the person or company whose account it is. 

A fictitious person is to be regarded as owning all the 
capital nominally intrusted to it and as owing its individ- 
ual members for their respective shares; consequently, 
there is no net capital-balance belonging to the fictitious 



Sec. 2] CAPITAL 41 

person, although in most cases there is a liability item 
called capital which represents what is owed to those 
most responsible for the management of the business. 
The most important example of a fictitious person is a 
joint stock company. This may be roughly described as 
an aggregation of individuals uniting for the purpose of 
holding property jointly, and so organized that the in- 
dividual shares of ownership and management are repre- 
sented by "stock certificates." Associated with the stock- 
holders are usually also bondholders without voting power, 
but with the right to receive fixed payments stipulated 
in the bonds which they hold. The " capital " item in 
the capital account of a joint stock company is a liability 
due to the stockholders. It represents what is left after 
the value of all other liabilities is deducted from the value 
of the assets. -^ 

The items in a capital account are constantly changing, 
as also their values ; so that, after one statement of assets 
and liabilities is drawn up, and another is constructed at a 
later time, the balancing item, or net capital, may have 
changed considerably. However, bookkeepers are accus- 
tomed to keep this recorded "capital" or "capital-balance" 
item unchanged from the beginning of their account, and 
to characterize any increase of it as " surplus " or " un- 
divided profits " rather than as capital. There are several 
reasons for this bookkeeping policy. In the first place, 
the less often the bookkeeper's entries are altered, the 
simpler the bookkeeping. Again, by stating- separately 
the original capital and its later increase, the books show 
at a glance what the history of the individual or company 
has been as to the accumulations of net capital. Finally, 
in the case of joint stock companies, the stockholders' 
capital is represented by stock certificates, the engraved 
" face value " of which cannot conveniently be altered 
to keep pace with changes in real value. Consequently, 
it is customary for bookkeepers to maintain the book 



42 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

value of the recorded " capital," or " capital-balance," 
equal to the face value of the certificates. But this book- 
keeping policy does not alter the fact that at a given instant 
the stockholders' capital consists of the entire excess of as- 
sets over liabihties, including in that excess the accumulated 
surplus and undivided profits. If the excess of assets over 
liabihties be added to the liabihties, the two sides of the 
account will exactly balance. A capital account so made out 
is therefore called a " balance sheet." 

The following two balance sheets illustrate the accumula- 
tion in a year of that part of capital which bookkeepers sepa- 
rate from the " capital " item and call " surplus." 

JANUARY 1, 1910 
Assets Liabilities 

Plant $200,000 Debts $100,000 

Capital (owed to the 

stockholders) . . 100,000 

$200,000 ' $200,000 

JANUARY 1, 1911 
Assets Liabilities 

Plant, etc $246,324 Debts $100,000 

Capital 100,000 

Surplus 46,324 

$246,324 $246,324 

Not only is the book item, " capital," maintained intact 
as long as possible, but often the surplus also is put in 
round numbers and kept at the same figure for several succes- 
sive reports. This leads bookkeepers to distinguish a third 
part of the capital, namely, the odd sum usually existing 
in addition to the surplus. This third item is called " un- 
divided profits," and is subject to constant fluctuation 
from one date to another. The distinction between sur- 
plus and undivided profits is thus merely one of degree. 



Sec. 2] CAPITAL 43 

The three items — capital, surpkis, and undivided profits — 
together make up the total capital-balance due the stock- 
holders. Of this, " capital " represents the original capi- 
tal, "surplus " the earlier and larger accumulations, and 
" undivided profits " the later and minor accumulations. 
The undivided profits are more likely soon to disappear in 
dividends, i.e., to become divided profits, although this may 
also happen to the surplus, or even in certain cases to the 
" capital " itself. -^^^ 

We see, then, that the capital of a company, firm, or 
person, is to be understood in two senses : first, as the item en- 
tered in the balance sheet under that head — the original cap- 
ital; and secondly, this sum plus surplus and undivided profits 
— the true net capital at the instant under consideration. 

In the case of a joint stock company, since the stock 
certificates were issued at the time of the formation of the 
company, and cannot be perpetually changed, they ordi- 
narily correspond to the original capital instead of the present 
capital. Recapitalization may be effected, however, by 
recalling the stock certificates and issuing new ones. In this 
way the nominal or book value may be either decreased or 
increased. It is sometimes scaled down because of shrinking 
assets, and sometimes increased because of new subscrip- 
tions or expanding assets. If, for instance, the original 
capital was $100,000, and the present capital (including the 
surplus and undivided profits) is $300,000, it would be pos- 
sible, in order that the total certificates outstanding might 
become $300,000, and the surplus and undivided profits be 
enrolled as capital, to issue additional stock certificates to 
the amount of $200,000 free to the holders of the original 
stock. Such an issue of stock is called a stock dividend. 
Ordinarily, however, the stock certificates remain as origi- 
nally, and merely increase in value. Thus, if the present 
capital is $300,000, whereas the original capital or the out- 
standing certificates amounted to only $100,000, the 
" market value " of the shares will be triple the " face 



44 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap, III 

value " ; for the stockholders own a total of $300,000, 
represented by certificates the face value of which is 

$IOOjOOO. 

§ 3. Book and Market Values 

If, however, we attempt to verify such a relation by refer- 
ence to the company's books, we shall find some discrepancies 
in the results. For instance, a certain bank of New York 
recently reported a total capital, surplus, and undivided 
profits of $1,295,952.59, of which the original capital was 
only $300,000. We should expect, therefore, that the stock 
certificates, the total face value of which was $300,000, 
would be worth $1,295,952.59 ; or, in other words, that each 
stock certificate with a face value of $100 would be worth 
$432. The actual selling price, however, was about $700. 
The discrepancy between $432 and $700 is due to the fact that 
there are two estimates of the value of capital — one that 
of the bookkeeper, which is seldom revised and usually 
conservative, and the other that of the market, which is 
revised almost daily. The stockholders of this bank were 
credited by the bookkeeper with owning $1,295,952.59, 
whereas in reality, the total value of their property was more 
nearly $2,100,000. The bookkeeper systematically under- 
valued the assets of the bank, and even omitted some valu- 
able assets altogether, such as " good will." The object of a 
conservative business man in keeping his books is not to 
obtain mathematical accuracy, but to make so conservative a 
valuation as to be well within the requirements of the law and 
expediency. The law discountenances the valuation of assets 
above their original cost ; and sometimes there is an addi- 
tional motive to undervalue, — the wish to conceal a large 
surplus, from fear either of competition or of taxation, v 

Of the two valuations of the capital of a company, the 
bookkeeper's and the market's, the latter, being more fre- 
quently revised, is apt to be the truer of the two, al- 
though it must be remembered that each of them is merely 



Sec. 4] CAPITAL ' 45 

an appraisement. The ordinary bookkeeper's figures, 
which have so imposing an appearance of accuracy, are, 
in reality, and often of necessity, very wide of the mark. 
For instance, a certain bank recently reported its capital, 
surplus, and undivided profits at $444,814.40, but at the 
same time the president of the bank boasted that the bank- 
ing house was entered among the assets at $20,000, while 
its real value was probably $50,000. Thus the figure giving 
the capital, surplus, or undivided profits, instead of being 
correct to the last cent or even the last dollar, was not 
correct even to the last ten thousand dollars. 

§ 4. Case of Decreasing Capital-balance 

We have seen that the effect upon the balance sheet of an 
increase in the value of the assets is to swell the surplus or 
the undivided profits. Conversely, a shrinkage of value 
tends to dirninish those items. For instance, if the plant of 
a company having a capital of $100,000 and a surplus of 
$50,000 depreciates to the extent of $40,000, the effect 
on the account will be as follows : — 

ORIGINAL BALANCE SHEET 

Assets Liabilities 

Plant .... $200,000.00 Debts .... $150,000.00 

Miscellaneous . . 101,256.42 Capital .... 100,000.00 

Surplus .... 50,000.00 

Undivided profits . 1,256.42 

$301,256.42 $301,256.42 

PRESENT BALANCE SHEET 

Assets Liabilities 

Plant $160,000.00 Debts .... $150,000.00 

Miscellaneous . . 101,256.42 Capital .... 100,000.00 

Surplus .... 10,000.00 

Undivided profits 1,256.42 

$261,256.42 $261,256.42 



46 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. Ill 

Here the shrinkage in the value of the plant, as recorded on 
the assets side, " comes out of the surplus," as recorded on 
the liabilities side. 

In case the surplus and undivided profits have both been 
wiped out, the capital itself becomes impaired. In this case 
the bookkeeper may indicate the result by scaling down the 
capitalization. This sometimes occurs in banks and trust 
companies, but not often in ordinary business. It is often 
avoided by making up the deficiencies through assessment 
of stockholders or postponement of dividends. Such meas- 
ures are sometimes required by law, as in the case of insur- 
ance companies. 

Dishonest concerns, however, often conceal their true con- 
dition by the reverse process of exaggerating the value of the 
assets. Sometimes this is done systematically, as in the case 
of stock-jobbing concerns. The sums intrusted to unscrupu- 
lous promoters by confiding stockholders are often invested 
in unwise or fraudulent ways. For instance, take an Oil 
Well Company in California, of the illegitimate type called 
" stock-producing wells." Suppose it borrows $50,000 and 
collects $50,000 more from the sale of stock (at par), and 
with this $100,000 purchases land at a fancy price from friends 
who collusively agree that a part of the proceeds shall be 
secretly returned to the promoter. In such a case the books 
of the bubble concern will show the following figures : — 

Assets Liabilities 

Land $100,000 Debts $50,000 

Capital 50,000 

$100,000 $100,000 

But if the land is worth, say, only $60,000, these accounts 
should have been quite different, viz. : — 

Assets Liabilities 

Land $60,000 Debts $50,000 

Capital 10,000 

$60,000 $60,000 



Sec. 4] CAPITAp' 47 

In other words, the investor has only $10,000 worth of 
property, instead of the $50,000 which he put in, or 20 cents 
for every dollar invested. The rest has been diverted into 
the pockets of the promoter and of those in collusion with 
him. 

This is stock jobbing. It is one example of what, in 
commercial slang, is called " stock watering," being an 
issue of stock whose nominal or face value is greater than the 
actual capital. Another ^d more usual use of the term 
" stock watering" makes it mean not an issue of stock beyond 
the original cost value of the capital as shown by the actual 
money paid in, whether or not this be beyond the real 
commercial capital- value. Thus a " trust " may buy up 
a number of factories and then capitalize them far beyond 
that cost, because the combination of the factories gives 
them a monopoly value beyond the sum of their values 
when separate. By this kind of stock watering, conceal- 
ment is made of the fact that the trust is earning an enor- 
mous rate of dividends in proportion to the original invest- 
ment ; for the dividends make a much smaller rate on the 
inflated, or watered, capitalization than on the cost value. 
Stock watering is usually employed to prevent a knowl- 
edge of the original value of the capital, for instance, to 
avoid public displeasure, taxation, or legal regulation of 
the rates charged. It is sometimes said that there is no 
wrong in such stock watering, so long as it is fully known. 
This is much like sa3dng that to lie is not wrong, pro- 
vided everybody knows you are lying. Stock watering 
of the kind described is the exaggeration of the " capital " 
item entered on the liabilities side of the balance sheet ; 
and, since the two sides must balance, it involves the 
exaggeration of the assets also. It usually represents an 
intention to deceive, and through this deceit injury may 
be done both to buyers of stock and buyers of bonds. 
The buyers of stock are injured if they buy without knowl- 
edge of the proposed stock watering, and the bond buyer 



48 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

is injured if the watering of the stock, having given him a 
false idea of the actual capital, induces him to lend more 
money than the capital can satisfactorily secure. 

§ 5. Insolvency 

The original capital of a concern may be either increased 
or decreased. It may even disappear altogether if the 
assets shrink so much as no longer to exceed the liabilities 
(other than the capital liability itself). Insolvency is the 
condition in which the assets fall short of the liabilities 
other than capital. The capital-balance is intended to 
prevent this very calamity; it is for the express purpose 
of guaranteeing the value of the other Habilities — those to 
bondholders and other creditors. 

These other liabilities, for the most part, are fixed blocks 
of property, carved, as it were, out of assets, the value of 
which property the merchant or company has agreed to keep 
intact at all hazards. The fortunes of business will naturally 
cause the whole volume of assets to vary in value, but all 
the " slack " ought properly to be taken up or given out by 
the capital, the surplus, and the undivided profits. A man's 
capital thus acts as a safety fund or buffer to keep the liabili- 
ties from overtaking the assets. It is the " margin " he 
puts up as a guarantee to others who intrust their capital to 
him. 

The amount of capital-balance necessary to make a busi- 
ness reasonably safe will differ with circumstances. A capi- 
tal-balance equal to five per cent of the liabilities may, in 
one kind of business, such as the business of a mortgage 
company, be perfectly adequate, whereas fifty per cent may 
be required in another kind. Much depends on how likely 
the assets are to shrink, and to what extent; and much, 
likewise, depends on the character of the liabilities. 

The risk of insolvency is the chance that the assets may 
shrink below the liabilities — to others than stockholders. 



Sec. 5] CAPITAL 49 

This risk is the greater, the more shrinkable the assets, 
and the less the margin of capital-value between assets and 
liabilities. 

Insolvency must be distinguished from insufficiency of 
cash. The assets may comfortably exceed the liabilities, 
and yet the cash assets at a particular moment may be less 
than the cash liabilities due at that moment. This condi- 
tion is not true insolvency, but only insufficiency of cash. 
In such a case, a little forbearance on the part of creditors 
may be all that is necessary to prevent financial ship- 
wreck. 

A wise merchant, however, will not only avoid insolvency, 
but also insufficiency of cash. He will not only keep his as- 
sets in excess of his liabilities by a safe margin, but he will 
also see that his assets are invested in such a manner that ,. 
he shall be able, by exchanging them for cash, to can9e'r 
each claim at the time and in the manner agreed upon. 

From this point of view there are three chief forms of 
assets ; namely, cash assets, quick assets, and slow assets. A 
cash asset is in actual money, or what is acceptable in place 
of money. A quick asset is one which may be exchanged for 
cash in a relatively short time, as, for instance, gold or silver 
bullion, wheat, short-time loans, and other marketable se- 
curities. A slow asset is one which m^y require a relatively 
long time to be exchanged for cash. Such are real estate, 
office fixtures, and manufacturers' equipment. ..y 

If all property were as acceptable as money, there would 
be no need of classifying assets into these three groups. 
But since the creditor will not accept railway stock or bonds, 
when he has contracted for pa5nnent in money, the debtor 
must maneuver so as to keep on hand a sufficient quantity 
of cash assets to enable him to meet his immediate obli- 
gations and enough quick assets to enable him to exchange 
them for cash in time to meet obligations soon to fall due. 
A large part of the skill of a business man consists in marshal- 
ing his assets so that he always has enough cash and enough 



50 ELEMENTARY PRINCIPLES OF ECONOMICS JChap. Ill 

quick assets to provide for impending debts, while maintain- 
ing at the same time enough slow assets to insure a satis- 
factory income from his business. /^ 

Originally, before business was separated from private life, 
all of a debtor's assets, even including his own person, were 
regarded as pledged to the payment of a debt. An insolvent 
debtor could be imprisoned. To-day, however, laws exist 
in most countries by which a bankrupt may, under certain 
conditions, be discharged, free from further liability. 

Since the liabilities of one man are also the assets of 
another, when one man fails and is able to pay only fifty 
cents on the dollar, the unlucky man who is his creditor — ■ 
who has the first man's notes as assets — suffers a shrinkage 
in his own assets which may in turn mean embarrassment 
or even bankruptcy to him. It is usually true in a panic that 
the failures start with the collapse of some big firm, involv- 
ing a shrinkage in the assets of others. This indicates why 
assets ought usually to be undervalued. A man who is in 
debt has no right to exaggerate his means of payment. A 
conservative and honest business man will always under- 
value rather than overvalue his assets, in order to be fair to 
his creditors. 

§ 6. Real and Fictitious Persons 

It is well to note here the distinction between the account- 
ing of real persons and of fictitious persons. For a real per- 
son, the assets may be, and usually are, in excess of the 
liabilities, and the difference is the capital-balance of that 
person. This capital is not, in the case of real persons, 
to be regarded as a liabihty, but as a balance or difference 
between the liabilities and the assets. For a fictitious 
person {i.e., a corporation, partnership, association, etc., 
regarded as independent of the real persons comprising 
it), on the other hand, the liabilities are always exactly 
equal to the assets; for the balancing item called capital 



Sec. 7I CAPITAL 5 1 

is as truly an obligation (from the fictitious person to the 
real stockholders) as any of the other liabilities. For 
instance, the items entered as " capital," " surplus," and 
"undivided profits" in the accounts of a joint stock company 
do not belong to the company, as such, but to the stock- 
holders. So far as the " company " is concerned, they are 
its liabilities; they represent what it owes to the stockholders, 
just as truly as the other items of liabilities represent what 
it owes to the bondholders, etc. A fictitious person, in fact, 
is a mere imaginary being, holding certain assets and owing 
all of them out again to real persons, including the stock- 
holders. A joint stock company may, it is true, be re- 
garded as consisting of real persons (stockholders, etc.). 
But if we prefer, it may be regarded as a separate entity. 
In this case, of course, the " company " becomes a mere 
bookkeeping dummy having no capital-balance of its own 
and apart from what it owes the stockholders. 

/ 

§ 7. Two Methods of Combining Capital Accounts 

We have seen how the capital account of each person in a 
community is formed. Our next task is to express the total 
net capital of any community. This is the sum of the net 
capitals of its members, i.e., all the innumerable assets of all 
the persons less all the liabilities of those persons. This net 
sum will be the same, of course, in whatever order the items 
are added and subtracted. We might write each item on a 
slip of paper, marking each asset item as positive and each 
liability item as negative, and, shuffling them into any ran- 
dom order, add and subtract them one by one according as 
they are positive or negative. But there are two ways in 
particular which need to be emphasized. / 

The simplest is, first, to obtain the net capital-balance of 
each person by subtracting the value of his liabilities from 
that of his assets, and then to add together these net capitals 
of different persons to get the capital of society. This 



52 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 



method of obtaining society's net capital may be called the 
method of balances; for we balance the books of each indi- 
vidual. The other method is to cancel each liability against 
an equal and opposite asset, which equal and opposite 
asset, as we shall see, must exist somewhere in another 
individual's account, and then add the remaining assets. 
This method may be called the method of couples; for we 
couple items in two different accounts. The method of 
couples is based on the fact that every liability item in a 
balance sheet impHes the existence of an equal asset in 
some other balance sheet. This is true because every 
debit impHes a credit. A debt may be owed to somebody, 
a creditor, as well as from somebody, a debtor, and the 
debt of the debtor is the credit of the creditor. It follows 
that every negative term in one balance sheet may be can- 
celed against a corresponding positive term in some other. 
Each of these two methods — of balances and of couples — 
is important in its own way. 

Let us illustrate each by the balance sheets of three real 
persons, say X, Y, and Z. 





PERSON X 




Assets 


Liabilities 




Z's note . . . . 
Residence . . . , 
Railroad shares . 


, $30,000 A Mortgage held by Y. 

70,000 ~^^ 
20,000 


$50,000 h 


Capital-balance 


$120,000 
$70,000 

PERSON Y 


$50,000 


Assets 


Liabilities 




X's mortgage . . 
Personal effects . 
Railroad shares . 


. $50,000 B Debt to Z . . . . 
. 20,000 
. 10,000 


$40,000 c 


Capital-balance . 


$80,000 
. $40,000 


$40,000 



Sec. 7] 




CAPITAL 






PERSON Z 




Assets 






Liabilities 


Y'sdebt . . . 


$40,000 


C Debt to X . . . 


Farm . . . ' . 


50,000 






Railroad bonds . 


20,000 








$110,000 




Capital-balance . 


$80,000 







S3 



$30,000 a 



50,000 



As the persons are real, not fictitious, the " capital " is 
in this case not a true liability, but is the excess of the 
total assets over the total liabilities. The sum of these 
capital-balances is the total net capital of X, Y, and Z, and 
is thus obtained by the method of balances. To show the 
method of couples in the table, each couple of corresponding 
items — i.e., each item which appears twice, once as a liability 
of one man and again as an asset of another — is indicated 
in both places by the same letter. Thus, " A " in X's 
assets is matched by the equal and opposite item " a " in 
Z's liabilities. The method of couples thus consists in 
cancehng, and, therefore, omitting from society's balance 
sheet, these pairs of items, and entering and adding only 
those which remain uncanceled. These, in the present 
case, are all assets. Adding these, we again obtain a sum 
representing the total net capital of X, Y, and Z, this time 
by the method of couples. 

The results of summing up the capital accounts by the 
two methods are shown in the following tables : — 



Method of Balances 



X's capital 
Y's capital 
Z's capital 



^70,000 
40,000 
80,000 



$190,000 



Method of Couples 

Residence $70,000 

Personal effects . . . 20,000 

Farm 50,000 

Railroad shares , . . 30,000 

Railroad bonds . . . 20,000 



$190,000 



The totals are the same by both methods, but the method 
of balances exhibits the share of this total capital which is 



54 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

owned by each individual, while the method of couples ex- 
hibits the portion ascribable to each different capital-good. 

§ 8. Ultimate Result of Method of Couples 

Let us now introduce into our addition the capital ac- 
counts of the railroad whose stocks and bonds were included 
among the assets of persons X, Y, and Z. For simpKcity, 
we shall suppose that these three persons are the only 
persons interested in the road. The balance sheet of the 
railroad company will accordingly appear as follows : — 

RAILROAD COMPANY 
Assets Liabilities 

Railway $50,000 Bonds (held by Z) . . $20,000 

Capital stock 
(held by X) $20,000 
(held by Y) $10,000 30,000 

$50,000 $50,000 

Capital-balance of the R.R. Co. itself $00,000 

If now, by the method of balances, we combine this balance 
sheet with those of X, Y, and Z, we shall see that its inclu- 
sion does not affect the results which were obtained by the 
same method before the railroad was introduced into the 
discussion. The totals will stand as follows : — 

X's capital-balance $70,000 

Y's capital-balance 40,000 

Z's capital-balance 80,000 

Railroad Co.'s capital-balance .... 00,000 

$190,000 
When we apply the method of couples, we find, however, 
that the inclusion in our consideration of the railway 
company's capital account will affect the items, though not 
the final sum. The stocks and bonds, as assets of X, Y, 
and Z, will then pair off or couple with the corresponding 
liabilities of the railroad company, and their place will be 
taken by the concrete railroad itself, as follows : — 



Sec. 8] CAPITAL 55 

Method of Couples 

Residence $70,000 

Personal effects 20,000 

Farm 50,000 

Railway . 50,000 

$igo,boo 

The appearance of the capital inventory is thus changed. 
Formerly, the items of property rights in it included such 
part-rights as stocks and bonds ; now they consist only of 
complete property rights. But the complete right to any 
article of wealth is best expressed in terms of the article of 
wealth itself. Consequently, instead of the long phrase, 
the " right to a residence," we may merely use the term 
" residence." The property no longer veils the wealth be- 
neath it ; and the inventory, which before was an inventory 
of both capital wealth and capital property becomes an in- 
ventory of only capital wealth. 

Such a result is sure to follow when we combine capital 
accounts, provided we combine enough of them to supply, 
for every liability item, its counterpart asset, and for every 
asset which has one, its counterpart Habihty. Those assets 
which have no counterparts are what we have called the 
complete rights to wealth; while those assets which do 
have canceling counterparts are the partial rights to wealth. 
The reason is that partial rights to wealth necessarily 
have canceling counterparts in that whenever any partial 
ownership of a given article of wealth is held by a partic- 
ular person, its whole ownership must be supposed to be 
held by some fictitious person even if specially created for 
the purpose. Thus, if a farmer named Smith owns an un- 
divided half interest in a farm jointly owned by himself 
and brother, we conceive of the whole farm as owned by 
the fictitious person, the partnership, known as the " Smith 
brothers." The owner of the half interest, " John Smith," 
thus holds a claim against the partnership " Smith broth- 
ers." This claim is an asset to Smith hut a liability to the 



56 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

partnership. It is clear that an individual cannot own a 
part interest in any given wealth without its being true 
that the fictitious owner of it all is liable to him to that 
extent. Therefore every partial right to wealth, while an 
asset to the owner of that right, is a liability to the ficti- 
tious person owning the whole. Every article of concrete 
wealth has to be regarded as owned by some one, even if 
we have to set up a fictitious person or dummy for that 
very purpose. 

To follow out totals of capital thus requires the inclusion 
of many fictitious persons, for it is often only the fictitious 
persons who hold the complete rights. Locomotives and 
railway stations, for instance, are owned by corporations, 
not individuals. In fact, these fictitious persons — partner- 
ships, corporations, trusts, municipalities, associations, and 
the like — are devices for the express purpose of holding 
large aggregations of concrete wealth and parceling out its 
ownership among a number of real persons. 

If, then, we suppose balance sheets so constructed as to 
include all the real and fictitious persons in the world, with 
entries in them for every asset and liability, — even public 
parks and streets, household furniture, and other possessions 
not formally accounted for in ordinary practice, — it is evi- 
dent that we shall obtain, by the method of balances, a 
complete account of the distribution of capital-value among 
real persons; and, by the method of couples, a complete 
list of the articles of actual wealth thus owned. In this list 
there wiU be no stocks, bonds, mortgages, notes, or other 
part-rights, but only land, buildings, and other land improve- 
ments, and commodities. All debit and credit items being 
two faced — positive and negative — cancel out in the total. 
This self-effacement, however, does not mean that the total 
would be just the same if there were no stocks, bonds, 
mortgages, notes, or other two-faced items. On the con- 
trary, the existence of such property rights indirectly adds 
a great deal to the effectiveness of wealth. They make 



Sec. 9] CAPITAL 57 

possible the cooperative ownership of great aggregations 
of capital which without such ownership could scarcely 
exist, and thus, result in increasing greatly the total bene- 
fits we enjoy from capital. 

§ 9. Confusions to be Avoided 

Among the forms of part-rights in real wealth is "credit." 
Credit is simply a debt looked at from the standpoint of the 
creditor. There has been much discussion as to the nature 
of credit. It has been sometimes regarded as an item of 
wealth; and an increase or inflation of credit has been 
looked on as a real addition to the wealth of the commu- 
nity. But, of course, since every credit is also a debit, it 
cannot be regarded as a simple addition to the wealth 
of the community as a whole. The phenomenon of 
credit means nothing more nor less than a specific form of 
divided ownership of wealth. Credit merely enables one 
man temporarily to control more wealth or property than he 
owns — i.e., some part of the wealth or property of others. 

It is, therefore, a cardinal error to regard credit as increas- 
ing the capital of the debtor. Indirectly, of course, credit 
may result in an increase of society's capital, by stimulating 
trade and production, as well as by getting the management 
of capital into the right hands and its ownership into the most 
effective form. In these ways the earth is made to yield up 
more wealth, or greater benefits from the same wealth — in 
either case entailing an increase of capital ; but the amount 
of any such increase of capital thus indirectly produced bears 
no necessary relation to the amount of the credit which 
facilitated its production. Even when capital is increased 
through credit, the credit does not constitute the increase. 

A great deal of confusion in legislation and discussion could 
be avoided if the two methods of combining capital accounts 
were distinguished and their interrelations recognized. In 
taxation, the two methods are often confused. An impor- 



58 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. Ill 

tant problem of efficient taxation of property is how to avoid 
unintentional double taxation and at the same time not to 
allow some property unintentionally to escape any taxa- 
tion. There are two solutions. One is to tax the amount 
owned by each real person as obtained by the method 
of balances ; this method seeks out the real owners or 
part-owners of wealth. The other is to tax the actual 
concrete wealth as obtained by the method of couples; 
this method seeks out the real wealth owned. In short, 
one method follows the person, the other the thing. At 
present the two methods are much confused. Legislators 
too often fail to perceive that under the first, or owner- 
method, corporations should not be taxed, for they are not 
true owners ; and that imder the second, or wealth-method, 
bonds, stocks, and other part-rights to wealth should not 
be taxed, for these are already taxed when the actual rail- 
ways and other items of physical wealth underlying such 
part-rights are taxed. It is not claimed, of course, that a 
complete system of taxation can be worked out merely by 
choosing one of the two methods just indicated. But the 
distinction between the two should be borne in mind, when- 
ever any scheme of taxation is considered ; for where one 
system is appHed, the other cannot also be appHed without 
double taxation. 

The study of capital accounting, therefore, enables 
us to avoid many common confusions. More important 
still, it gives us a clear picture of the relations between the 
capital of a community and the capital of the individuals 
of which the community is composed, i.e., between the 
stocks of actual wealth in a community and the stocks of 
property representing the ownership of this wealth among 
different individuals. In short, it enables us to see both 
individually and as a whole the items which make up private 
and collective property, as stocks, bonds, mortgages, debts, 
etc., on the one hand, and land, ships, dwellings, and other 
concrete wealth, on the other. 



Sec. 9] CAPITAL 59 

In the light of the foregoing principles we are in a position 
to take a bird's-eye view of the capital in any country. In 
America, for instance, we find a stock of wealth of various 
kinds with an estimated value of over $100,000,000,000, 
More than half of this consists of real estate; about ten 
per cent consists of railways and their equipment ; manu- 
factured products make up about $8,000,000,000 ; furniture, 
carriages, and kindred articles about $6,000,000,000 ; live 
stock on farms about $4,000,000,000 ; tools, implements, 
and machinery in factories about $3,000,000,000; clothing 
and personal adornments about $2,500,000,000; street 
railways about $2,000,000,000; agricultural products about 
$2,000,000,000; gold and silver coin and bullion about 
$2,000,000,000 ; and there are numerous other smaller items. 
The ownership of this real wealth is divided up in various 
ways. To a very large extent, especially in the case of farms, 
the real estate is owned completely by the occupier. In other 
cases it is mortgaged, the occupier then owning merely the 
excess of value over the mortgage. Of the national capital 
apart from real estate, on the other hand, probably by far 
the greater part is owned by corporations, which means, of 
course, simply that its ownership is parceled out among the 
stockholders and bondholders of these corporations. From 
what has been said the student will not make the mistake 
of adding the value of stocks and bonds to the value of 
the tangible wealth which these represent. Stocks, bonds, 
mortgages, and other items which are assets to some persons 
are liabilities to others, and thus cancel themselves out for 
the country as a whole. The student will also notice how 
insignificant is the stock of gold and silver as compared with 
the total capital, although the value of all is measured in 
terms of gold. 



CHAPTER IV 

INCOME 

§ I. Concepts of Income and Outgo 

The income from any particular article of wealth has been 
defined as the flow of benefits from that article. These bene- 
fits may sometimes consist of money payments; but it is 
important to avoid the mistaken notion that they always 
consist of money payments. Income is the flow of whatever 
benefits accrue from any article, whether these benefits 
happen to be in the form of money payments or not. A self- 
supporting farmer, for instance, may not receive or expend 
a single dollar from one year's end to the other. He has, 
nevertheless, an income. He gets a " living " — the very 
essence of income — from the farm. A windmill pumps 
water ; the pumping is the benefit or income resulting from 
the windmill. A derrick hoists coal from a mine ; the hoist- 
ing is the income from the derrick. A wife does housework ; 
her work is an item of the family's income, for, as was 
stated in the last chapter, the services of a human being 
are income. The warmth and shelter that a house provides 
for its occupants constitute the income furnished by the 
house. All the operations of industry and all the transac- 
tions of commerce are items of income. When axes fell 
trees and sawmills turn them into lumber, these changes 
constitute items in the income flowing from the agencies 
which produce them. When a manufacturing plant con- 
verts raw materials into food or into fabrics or into imple- 

60 



Sec. i] income 6 1 



merits, these changes constitute income produced by the 
plant. What we call agriculture, mining, commerce, and 

/ 



domestic operations constitute large and important classes 



of income. 

Practically, of course, most of the examples given of bene- 
fits or services are not income to the owner of the instru- 
ments rendering those services; for, practically, those 
services are not enjoyed by the owner, but are sold to some 
one else, the owner receiving a money payment instead. 
Thus, although a farmer may get his living directly from the 
farm, it is more usual for him to sell some of the farm products 
and to receive money payments instead. Likewise it may 
be that the owner of the windmill pumps water for others 
and receives money payments in return; and that the 
owner of a house sells its use for a money rental. Simi- 
larly the owners of the derrick, axes, sawmill, manufacturing 
plant, etc., do not get the direct benefit of the hoisting, 
cutting, sawing, manufacturing, etc., but exchange these for 
money payments. In such cases the owners get their in- 
come in the form of money payments by selling to others 
the direct benefits of their capital. Thus their capital yields 
them an indirect money income through the sale of the direct 
income produced by the capital. So usual is it for the owner 
of capital to sell his direct or natural income for a money 
income that ordinarily we think of income as consisting only 
of such money return. One of the early economists seri- 
ously maintained that the owner of a house could receive 
no income from it except by renting it, forgetting that to 
let a house is merely to sell the shelter income for money 
income. A man who lives in his own house gets the shelter 
income directly. A man who lets his house to another 
secures a money income as the equivalent of the shelter in- 
come which he sells to the tenant. | 

Income, being a flow of benefits, impHes a stock or fund 
which produces the flow. This stock or fund may consist 
partly of instruments of external wealth, which we have 



62 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

designated as capital (in the narrow sense) , and partly of 
the population itself, which is also capital (in the broader 
sense). 

It has already been noted that income differs from capital 
in two respects. In the first place, income is a flow relating 
to a given period, whereas capital is a stock or fund relating 
to a given instant. In the second place, income consists of 
(intangible) benefits, whereas capital consists of (tangible) 
instruments ; not farms, therefore, nor houses, nor food, nor 
railroads, nor artesian wells, nor instruments of any sort can, 
strictly speaking, ever constitute income. Income consists 
rather in the yielding of crops by the farms; the warming 
and sheltering of people by the houses; the nourishing of 
people by the food ; the transporting of passengers and 
freight by the railroads ; the raising of water by the wells ; 
and benefits of any sort rendered by instruments of wealth. 

Although income consists partly of other benefits than 
money receipts, all income, like all capital, may be translated 
into terms of money. For, as was pointed out in chapter 
II, § I, to all items of income, i.e., benefits, may be applied 
the concepts of price and value. 

Income, as well as capital, is subject to accounting. 
Thus far we have considered only such items as would 
belong to the positive side of income accounts. But just 
as in our capital account we found a negative side — com- 
prising the liabilities — so we shall find a negative side 
to income. The negative of income is called outgo, and 
the items which constitute outgo are called costs. A cost 
occasioned by an article has already been defined as the 
opposite of a benefit. It is an undesirable event occa- 
sioned by that article. Labor, trouble, expense, and sacri- 
fices of all sorts are entailed by wealth and are counted 
among its costs. An instrument seldom confers benefits 
without also involving costs. A dwelling, while it gives 
shelter, compels its owner to assume important costs in 
keeping it in repair, painting it, cleaning it, caring for it, 



Sec. i] income 63 

insuring it, and paying taxes upon it. A saddle horse yields 
income to the owner when it gives him a pleasure ride, but 
it requires feeding, stabling, and shoeing — the negative side 
of the account, constituting the outgo or flow of costs oc- 
casioned by the horse. A farm produces benefits in yielding 
crops ; but it requires fertilizing, tilHng, and seeding, all of 
which are costs occasioned by the farm. A railroad pro- 
duces benefits called "' transportation" — hauling passengers 
and commodities ; but it involves an expenditure of money, 
it burns coal, it requires labor ; and these are the outgo, or 
the negative side of its account. / 

Costs, too, may be measured in money just as income may 
be measured in money ; and some costs, whether of dwel- 
lings, farms, railways, or other articles, consist in the actual 
expenditure of money, just as some benefits consist in the 
receipt of money. Strictly speaking, neither consists of actual 
money. We must, therefore, distinguish carefully three 
money items : (i) money on hand at an instant of time, 
which is an example of capital ; (2) the receipt of money 
during a period of time, which is an example of income (from 
whatever instrument occasions the receipt of the money) ; 
and (3) the expenditure of money during a period of time, 
which is an example of outgo (on,/the part of whatever instru- 
ment occasions the expense). / 

In general, the costs of a given item of capital are out- 
weighed by its benefits. For if it should occasion more 
costs than benefits, it would be thrown away, thereupon 
ceasing to be wealth according to our definition. Or if it 
should still remain in any one's possession, it might be called 
negative wealth, of which ashes, rubbish, garbage, etc., are 
familiar examples. ^ 

Costs, then, are never voluntarily assumed except in the 
hope of benefits which will make them worth while. The 
total value of all the benefits flowing from a given instrument 
in a given time is called gross income-value or simply 
gross income, during that time. Similarly, the total value 



64 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

of its costs is called outgo-value or simply outgo. The 
total gross income during a given time minus the total 
outgo {i.e., the value of its costs), constitutes net income. 
Thus, just as net capital is found by subtracting the lia- 
biHties from the assets in a capital account, so net income 
in an income account is found by subtracting the value 
of the costs from the value of the benefits. Both benefits 
and costs, moreover, are attributable to a definite capital 
source. In income-accounting the benefits or income-items 
are credited^ to capital, and the outgo or cost-items are 
debited to capital. In keeping income accounts, therefore, 
it is important to know to what category of capital any item 
of income should be credited, or any item of outgo debited. 



§ 2. Income Accounts 



/ 



We are now in a position to apply the foregoing definitions 
to income accounts. Perhaps no other subject in economics 
has been so fraught with confusion, misunderstanding, and 
double counting, as income. It will help the student to 
understand these accounts if he will bear in mind that they 
show the income and outgo which any given capital (or free 
human being) yields. We are apt to thinlc of income and 
outgo too much with reference to the owner of the income 
instead of the source of the income. It will be easy later 
to make up the owner's income account ; but first we must 
construct the income account for an isolated article of capital. 

We may begin by imagining a certain " house- and-lo t- ". 
as one composite instrument or article of wealth, and may 
first consider its income and outgo during the calendar 
year 1910. The instrument is capital, and the income which 
this capital brings to its owner may be either a money rental 
or the direct shelter and similar benefits of the house enjoyed 
by himself and his family. In either case the income may 
be measured in money, although in the case of occupancy 
by the owner this measurement requires a special appraise- 



Sec. 2] INCOME 65 

merit. The house, let us suppose, was built many years 
ago, and is now nearly worn out. It yields an income worth 
$1000 a year. • Against its income there are offsets in the 
form of repairs, taxes, etc. — costs which it occasions. We 
have, then, the following " income account " : — 

INCOME ACCOUNT FOR HOUSE AND LOT DURING THE 

YEAR 1910 
Income Outgo 

Use of house and lot . . $1000 Repairs $200 

Taxes 180 

Insurance 20 

$1000 $400 

Net income .... $600 

Next year the house is found to have rotten timbers, is 
condemned, and must be abandoned or torn down. Its 
benefits are ended, but the land is still good, and the owner 
can build a new house. The period consumed by this opera- 
tion is the first six months of the year 191 1, so that during 
such period there is no income attributable to the house and 
lot, but only outgo. During the second half of the year the 
house is occupied, and its use is valued at $600. In the first 
six months not only did the " house-and-lot " fail to yield 
any income, but it occasioned a cost. This .cost was the 
cost of production of the new house. 

We have, then, the following account : — 

INCOME ACCOUNT FOR HOUSE AND LOT DURING THE 
YEAR 1911 
Income Outgo 

Use of house and lot (six Expense of building 

months) , $600 house $10,000 

Taxes and insurance . 100 

$600 $10,100 

Net outgo $9,500 

During this year, then, the house causes a net outgo of 
$9500. As we know, all costs are " necessary evils " ; they 



66 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 



lead to good, though not good themselves ; and this cost of 
constructing the house was incurred only for the sake of 
expected future benefits. The adverse balance it creates is 
only temporary, and should be more than made up in the 
years which follow. 

For the year 191 2, for instance, we may have the follow- 
ing : — 

INCOME ACCOUNT FOR HOUSE AND LOT DURING THE 

YEAR 1912 

Income Outgo 

Use $1300 Repairs $ 50 

Taxes and insurance . . 250 
$1300 $300 

Net income $1000 

These figures remain about the same for forty-nine years 
and give $49,000 net income during that time, offsetting the 



tSI3 I9I-4- 1915 ISI6 1917 



INCOME 
Sheltar 



m 



m. 



1300: 






OUT60S 



m 

i 

II 



Fig. 2. 



excess in cost for 191 1 ($9500) and leav- 
ing a large margin besides. Then the 
house is worn out a second time and has 
to be rebuilt. The same cycle is repeated, 
one year of excess of cost being offset by 
forty-nine years of excess of income. Figure 2 shows a 
part of this cycle, picturing graphically the figures in the 
above income-and-outgo accounts. 

It will be observed that the cost of reconstructing the 
house was entered in the accounts in exactly the same way 
as the cost of repairing it or as any other costs. This may 



Sec. 3] INCOME 67 

be puzzling at first, because most of the other costs are 
fairly regular year by year, whereas the cost of reconstruc- 
tion occurs only once, or at any rate only once in a long while. 
It may also seem puzzling because the cost of reconstruc- 
tion is so large in comparison with other costs. But the 
irregularity or size of costs is, of itself, no reason for omitting 
them from our accounts. The only way in which we can 
escape recording such a cost — for instance, the cost of 
constructing the house — is by substituting in its place an 
equivalent series of smaller and more regular costs. What 
is called a depreciation fund is sometimes created for this 
very purpose. This fund is accumulated during the exist- 
ence of the house by setting aside annually small portions 
of the income yielded by the house, sufhcient in the aggre- 
gate to replace the house when it is worn out. The depreci- 
ation fund, combined -with the " house-and-lot " renders 
the flow of costs uniform or regular. But even when a 
depreciation fund is used, we can only say that the com- 
bination of the two things (the fund and the house) has a 
regular cost. We cannot say that this is true of the house 
hy itself; and when no such device as a depreciation fund 
at all is used, there can be no escape from charging the cost 
of reconstruction in precisely the same way as we charge any 
other cost. If this still seems puzzling, it is because we are 
in the habit of seeing the cost of reconstruction entered as 
the value of the house and, hearing it called, for that 
reason, a " capital cost." It is true that the value of the new 
house must be entered on the capital-balance sheet; but 
the cost of producing it belongs properly to the income ac- 
count. The value relates to an instant of time (which 
may be any instant from the time the house is begun till 
the time when it ceases to exist) ; the cost relates to a period 
of time (which may be all or any part of the time during 
which the labor and other sacrifices occasioned by the house 
occur). The value of the house is quite distinct from the 
series of costs by which it was built, although the confusion 



68 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap, IV 

between the two is natural in view of the bookkeeping 
practice of entering capital at its " cost value." The house 
on which $10,000 was expended for construction may be 
worth either more or less than $10,000. In either case the 
income account should contain $10,000 on the outgo side, 
and the capital account a larger or smaller figure, as the 
case may require. 

§ 3. Devices for Making Net Income Regular 

We have seen that the irregularities in the net annual 
income or outgo flowing from the " house-and-lot " may be 
combined with the opposite irregularities of the net an- 
nual outgo or income from a " depreciation fund," so that 
the net result from the two combined is a steady net in- 
come. The same result may be secured in other ways. 
For instance, if the owner of the house-and-lot happens to 
own a large number of other houses-and-lots in different 
degrees of repair, the irregularities in income from them in- 
dividually may tend to offset each other. Thus, if a man 
owns fifty houses, each lasting fifty years, and every year 
one wears out and has to be rebuilt, it is then evident 
that he will have an expense of $10,000 every year for the 
rebuilding of a house, which will be a regular item; and 
he will have a regular income balance as a consequence, 
because he will get the benefit of forty-nine houses, which 
will far outweigh the cost of building only one. The differ- 
ence will be his net income, which will be a fairly regular 
amount year after year. 

This example ought to set at rest any Kngering doubts 
as to the correctness of our including the cost of recon- 
structing a house as an item of outgo, to be entered as 
such in a true and complete income account. The only 
reason this may, at first, seem wrong is that the cost of 
reconstruction is not usually a regular item. In the case 
of the fifty houses it becomes a more or less regular item. 



Sec. 4] INCOME 69 

But if it is correct to call it outgo when there are fifty- 
houses, it must be correct to call it outgo when there are 
ten houses or when there is only one. Irregularity of in- 
come is an inconvenience and we usually seek to avoid it 
by depreciation funds, by having a large number of articles 
at different stages of repair, or otherwise. But so long as 
irregularity of income exists it must be entered as such. 
The effect of reducing irregularities by combining a large 
assortment of articles is present wherever a sufficiently 
large assortment exists. Professor Clark of Columbia Uni- 
versity suggests a helpful simile when he compares a stock 
or fund of capital to a waterfall : the drops of water, or 
component parts of the waterfall or fund, are constantly 
changing; but the waterfall or fund remains substantially 
the same. 

§ 4. How to Credit and Debit 

Before leaving the subject of income accounts, we shall 
speak of one particular kind of capital, namely, a stock of 
cash. This will furnish an opportunity to illustrate anew 
some of the principles of accounting which we have just dis- 
cussed. What puzzles the novice in accounting is the manner 
of debiting and crediting a stock of cash, or what is called 
the " cash drawer." At first sight the usage seems to be the 
opposite of what it should be. To understand the practice 
of accountants in this particular is to go a long way toward 
understanding the main principles of accounting. It will 
help us to understand it if we liken a cash drawer to a gold 
mine. We credit a gold mine with all the gold extracted, 
and we debit it with all the costs put into it. In the case of 
the gold mine, what it costs to run it is outgo; all of the 
3^eld of gold is gross income ; and the difference is the net 
income. Similarly, the gross income from the cash drawer 
consists of what the cash drawer yields, or whatever comes 
out of it. It benefits us whenever it pays our bills ; it costs 
us whenever we pay its bills, i.e., whenever we pay some- 



70 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. IV 

thing into it. All the pa3TTients which we have to make to 
the drawer are a cost of that drawer to us, whereas all the 
payments that we make hy the drawer are the benefits which 
it produces for us. As long as we pay money into the drawer, 
we realize no income, but merely accumulate capital for 
future use. If we should only pay money into the drawer and 
never throughout our life take any out, the "drawer " would 
benefit us nothing. Its benefits would go to our descendants 
whenever they should take the money out. Ordinarily, 
however, the money is taken out soon after it is put in. What 
net benefit, then, does the cash drawer yield in the long run ? 
Seldom anything at all. We pay out just as much as we 
put in ; and if we subtract one amount from the other, the 
net annual income from the cash drawer will be about zero, 
unless during a certain year we store up more than we take 
out, or take out more than we put in. 

The reason that these credits and debits of " cash " seem 
at first the reverse of what they should be is that we are ac- 
customed to think of money receipts and expenditures, not 
in their relation to the stock of cash into or out of which they 
are paid, but in their relation to some other item of wealth 
on account of which the payments are made. If a lodging- 
house keeper receives $io from a lodger and puts it into her 
cash drawer, she finds it hard to debit $io to " cash." She 
thinks of the $io as income ; and it is income with respect to 
her lodging-house J for the latter has yielded it to her. Her 
stock of cash, however, has not yielded the $io to her. On 
the contrary, it has taken that amount from her. Later on 
it will yield back that amount or some portion of it, and 
at that time may properly be credited with the sum it 
)delds up. 

We are now ready to understand how to derive a man's 
total income. It is simply the combined income from all 
the capital he owns. We could obtain a full account of it by 
keeping a separate income account for each item of capital 
he owns, crediting and debiting each such item with its re- 



Sec. 4] mCOME 7 1 

spective benefits and costs. The difference of all the benefits 
and costs of all his capital is his net income. In these 
accounts we should include, therefore, all positive and nega- 
tive items of income pertaining to all positive and nega- 
tive items of capital. The negative items of capital are 
the liabilities. Liabilities yield a net outgo instead of a 
net income. In order, then, to find out the net income of 
any person during a certain day or month or year, the 
proper method is to make a complete statement of all his 
assets and all his liabihties ; and for each asset as weU 
as each liability, credit all the benefits and debit all the 
costs. The net result will be the net income of the 
person. 

A real person will have a net income, but a fictitious 
person will not. We have seen, in the case of fictitious per- 
sons, that there is no net capital because the Habilities always 
equal the assets ; for what is often called the capital of a 
"company" really means the capital of its stockholders. As 
there is no net capital of the company, as such, the " com- 
pany " owing it all to the stockholders, so there is no net 
income of the company, as such, the " company " pa3ang 
it all to the stockholders or others. 

The following is an imaginary income account of a rail- 
road company : — 



INCOME ACCOUNT OF A 


RAILROAD CORPORATION 


Income 


Outgo 




y passenger and 


To operating expenses 


$800,000 


freight service . $1,246,147 


To interest to bond- 






holders .... 


100,000 




To dividends to stock- 






holders .... 


200,000 




To surplus applied to 






(i) purchase of land 


140,000 




(2) cash paid into 






treasury . , . 


6,147 



11,246,147 $1,246,147 



72 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

The passenger and freight service has yielded $1,246,147. 
That is the gross income of the road. All the benefits flowing 
from that road are worth this amount of money. On the 
other side of the railroad account we find the costs of the 
road to the company; they exactly equal the benefits, for 
the company is an abstraction — a mere holding concern — 
not a real individual. The outgo consists principally of 
operating expenses, $800,000; interest to bondholders, 
$100,000 ; dividends to stockholders, $200,000. The words 
hy and to are usual in income accounts. The receipts are 
benefits ; they come hy virtue of the services designated. 
The costs represent something which has to be given to 
these several items in order to make the benefits possible. 
These items leave a surplus, part of which is expended for 
land ($140,000) ; this is a cost just as much as anything 
else. Then there is cash left in the treasury to the amount 
of $6147. It must not be concluded that this cash is a net 
income. The cash drawer swallows it up. The company 
loses $6147, so to speak, in feeding its cash drawer. There- 
fore the two sides of the account balance, and there is no 
net income at all to the "company." 

§ 5. Omissions and Errors in Practice 

Practically, however, it is not convenient to enter in an 
income or a capital account everything which theoretically 
ought to be entered there. Moreover, capital and income 
accounts are not always treated consistently in practice. 
For instance, in a capital account a man would not ordi- 
narily enter his own person, as a free human being is not 
ordinarily counted as wealth ; and yet in his income ac- 
count he will enter the money he earns or the work that 
he does. That is, work and wages are entered in the income 
accounts, but the corresponding items representing the 
agencies which do this work or earn these wages are not 
entered in the capital accounts. The correspondence be- 



Sec. s] income 73 

tween the two accounts is, therefore, obscured. On the other 
hand, a man never, in practice, enters in his income account 
the shelter of his own house as a benefit, and yet he may 
include the house among his assets in his capital account. 
In ideal accounting we should insist upon recording every 
benefit of any kind, every cost, and every source of benefit 
or cost. As we have already indicated, an early economist 
fell into error when he said that a dwelKng occupied by the 
owner yields no income. He claimed that, on the contrary, 
it is a source of expense. Evidently he had in mind only 
those costs and benefits which come in the form of money 
payments. One certainly gets no money benefits by living in 
his own house, while he does suffer a money cost to run it. 
So far as money receipts and expenditures are concerned, 
therefore, the house costs more than it brings in. But no 
man would keep his house if it did not afford him benefits 
greater than its costs. We should, therefore, appraise the 
shelter of the house and enter this as its gross income. 
If we do not, we reach the absurd conclusion that if I live 
in my own house and you live in your own house, neither of 
us receives any income ; but if you rent your house to me 
and I rent mine to you, then we shall each be receiving 
income ! Obviously the income is really there, all the time, 
in the form of shelter ; and when one man rents another 
man's house, he gets the shelter-income and gives the other 
man a money-income in its place. 

An account of money received and expended by a given 
person can sometimes furnish a fairly complete picture of 
his income ; but only when two conditions exist ; namely, 
that all the income from his property is in the form of 
money, and all the outgo is in the form of money spent 
for personal satisfactions {i.e., goes directly to pay for 
clothes, food, shelter, amusements, and the like, and is not 
expended in investments, repairs, and the expenses of run- 
ning a business). Under these conditions the cash drawer 
and the cash account constitute a kind of money meter of 



74 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IV 

income. These conditions are approximately fulfilled when 
people live in a city and rent the houses or furniture of 
others instead of owning them themselves. Such people 
get practically all of their income in the form of money 
receipts, as salaries, dividends, and interest. This money 
is spent for benefits, as food, clothing, theater going, etc. 
The cash drawer (or bank account) then intervenes be- 
tween the money-income on the one hand, and the final 
income which this money-income buys, on the other hand ; 
much as a cogwheel intervenes to transmit motion from 
one part of a machine to another. A man who receives 
$5000 a year in money or checks and spends it all on 
food, clothing, shelter, amusements, and other final or 
enjoyable benefits, and gets no such benefits from any 
other source, evidently receives a real income of $5000 
a year. His money income correctly measures his real 
income. But if he " saves " part of the $5000, i.e., ex- 
pends it for stocks, bonds, or a savings bank account or 
any other capital, the benefits from which are greatly de- 
ferred, his real income may be less than $5000 ; while if 
he derives shelter from his own house, or food from his 
own garden, his real income may be greater than his 
money income. Thus money income is an unsafe indica- 
tion of real income. The only method, then, of construct- 
ing income and outgo accounts which will be correct and 
which can serve as a basis for economic analysis is the 
method already indicated — the method by which are re- 
corded, for each article of capital (including human beings), 
the values of all its benefits and all its costs. These benefits 
and costs are of many kinds. Sometimes they consist of 
money payments — not in themselves enjoyable to anybody ; 
sometimes they consist of merely intermediate or produc- 
tive operations ; and sometimes, of truly final or enjoyable 
elements. All these items should be entered in the accounts 
on the same footing ; but we shall see that all except the 
" enjoyable " elements will cancel among themselves. 



CHAPTER V 

COMBINING INCOME ACCOUNTS 

§ I. Methods of " Balances " and " Couples " 
" Interactions " 

We have now learned how to reckon the income of either 
a real or a fictitious person. Of reckoning the income of all 
society, on the other hand, there are many ways, including, 
in particular, two that correspond to the two ways which we 
discussed in Chapter III of reckoning society's capital. 
These are the method of balances and the method of 
couples. The method of balances is very easy to apply. All 
that is necessary is to make up an income account for any 
given period for each instrument or article of wealth so as 
to include all possible income or outgo in society and,, de- 
riving from each such account the net balance, add these 
net balances together. The result is the total income of 
society. Its constituent parts are the net incomes from 
the several articles of society's wealth. 

The " method of couples " is somewhat more difficult to 
follow. But it is also more important. Just as it often 
happens that the same item in capital accounts is both asset 
and liability, according to the point of view, and is therefore 
self-canceling, so it often happens that the same item in 
income accounts is both benefit and cost, and is, therefore, 
likewise self-canceling. In fact, the reader may have felt 
that, in many of the examples cited, what we called costs 
were really benefits. He may have asked himself: Why 

75 



76 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

should we call repairing a house a cost ? When a carpenter 
and his tools repair it, do we not credit him and them with 
a service performed? Is not any production a benefit? 
Have we not, then, placed repairs on the wrong side of the 
ledger ? It all depends upon which of two accounts we are 
considering. When a carpenter with his plane, hammer, and 
saw helps to rebuild a house, we have to consider two groups 
of capital.-^ One group, the carpenter and tools, is acting on 
the other group, the house. The carpenter and tools cer- 
tainly perform a service or benefit, but the house does not. 
Considered as occasioned by the house, the repairs are costs. 
The house absorbs or soaks up these costs, promising to com- 
pensate for them by benefits to be yielded later on. The 
renailing of loose shingles is certainly not what the house is 
for ; with respect to the house, it is a necessary evil ; with 
respect to the hammer, however, it is a service rendered. 
Therefore the repairing of the house is at once a benefit and 
a cost. 

Such double-faced events are so important as to require a 
special name. We shall call them interactions. Each inter- 
action takes place between two instruments or groups of 
instruments. 

An interaction, then, is a double-faced event, at once a bene- 
fit or service of the acting instrument, and a cost or disserv- 
ice of the instrument acted on. There can never arise the 
slightest doubt as to when it is to be regarded as positive and 
when negative. The definitions of benefit and cost settle 
this question in each case. If it is desired by the owner of 
a given instrument that this instrument should occasion a 
given event, then the event is "desirable" or a benefit. 
If it is desired that an instrument should not occasion a 
given event, then the event is "undesirable" or a cost. 
Thus, since the house owner desires that the house should 
not occasion repairs, these repairs are costs of the house; 

^ In this instance and throughout the following discussion we shall 
consider capital in its broader sense as including free human beings. 



Sec. 2] COMBINING INCOME ACCOUNTS 77 

and. since he desires that the tools should produce repairs, 
such repairs are the benefits from those tools. 

The exampLe given is typical of the general relations be- 
tween interacting instruments. The mental picture we 
should construct is that of two distinct groups of capital. 
Group A acts on, and, so to speak, benefits Group B. What- 
ever the nature of this interaction, A, the giver of the bene- 
fit, is credited with it and B, the recipient, is debited with 
it as a cost. These two items of credit and debit are equal 
and simultaneous because they are the selfsame event 
looked at from opposite sides. 

Interactions constitute the great majority of the elements 
which enter into income and outgo accounts. The only 
benefits which do not form merely the positive side of such 
canceling interactions, and so do not cancel out, are satis- 
factions — desirable conscious experiences — often called 
" consumption " (these are credited to the things enjoyed 
— for instance, a house) ; and the only costs which do 
not form merely the negative side of such canceling inter- • 
actions, and so do not cancel out, are " labor and trouble " 
(these are debited to human beings). But these two 
final elements — " satisfactions," on the one hand, and 
"labor and trouble," on the other — are only the outer 
edges of the series of interactions. Between them lies a 
connective chain of productive processes and commercial 
transactions, every link of which has two sides, a positive 
side of benefits or services and a negative side of costs, 
always mutually canceling. 

§2. Production: Interactions which Change the Form of 

Wealth 

The interactions between two articles or groups of articles 
are of three chief kinds : changes in the form of wealth, 
changes in the position of wealth, and changes in the owner- 
ship of wealth ; in other words, transformation, transporta- 



78 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. V 

tion, and transfer or exchange. All three may be called 
"production," although this term is sometimes confined to 
the first two and sometimes even to the first alone. These 
we shall take up in order, and show how each is a two- 
faced event or an interaction. 

First, what is here called " transformation " of wealth is 
practically identical with what is usually understood by 
'' production " or " productive processes." By this trans- 
formation or change in the form of wealth is meant the 
change of relative position of its parts. Weaving, for 
instance, is the transformation of yarn into cloth by a re- 
arrangement in the relative positions of the warp and woof. 
Spinning, likewise, consists in moving, stretching, and twist- 
ing fibers into yarn ; sewing, in changing the position of 
thread so that it may hold cloth together; and so it is 
with carding, wool sorting, shearing, and all the other 
operations which constitute the manufacture of fabrics. 
All these operations^ — which include all manufacture and all 
agriculture — consist simply of a series of transformations 
of wealth, each transformation being a two-faced operation. 
With respect to the transformed instrument or instruments, 
the transformation is a cost ; with respect to the transform- 
ing instrument or instruments it is a benefit. So it is 
when a loom produces cloth out of yarn, or when land 
renders a service in producing wheat. So it is, not only 
when a carpenter and his tools build or repair a house, 
but also when the painter decorates it or the janitor 
cleans it ; or when a cobbler transforms leather into shoes, 
or when a bootblack transforms dirty shoes into clean and 
polished ones. 

The principle is not altered when the interaction consists, 
not in producing a change, but in preventing one. A ware- 
house renders its service as a means of storing bales of cotton, 
i.e., protecting them from the elements ; and this storage is, 
on the part of the stock of cotton, an element of outgo, or ex- 
pense, as on the part of the warehouse it is an item of income. 



Sec. 2] COMBINING INCOME ACCOUNTS 79 

Nor is the principle altered when there are, as indeed is 
usually the case, more articles than one in either or both of 
the two interacting capitals. Plowing, or the transformation 
of land into a furrowed form, is performed by a plow, a 
horse, and a man. The plowing is a cost debited to the land, 
on the one hand, and at the same time a service credited to 
the group consisting of the plow, horse, and man, on the 
other. 

Nor is the principle altered if one or more of the trans- 
forming agents perish in the transformation and another 
comes for the first time into existence. Bread making is a 
transformation debited to the bread and credited to the cook, 
the range, the flour, and the fuel, of which the last two are con- 
sumed as soon as they perform their services. Agents which 
disappear in the transformation, but reappear in whole or 
in part in the product (as here the flour), are called " raw 
materials." The production of cloth from yarn is a trans- 
formation effected by means not only of the loom, but also of 
a number of other agents, among them the yarn itself, 
which thus vanishes as yarn and reappears as cloth. The 
cost of weaving includes the consumption of raw material 
— yarn ; and this consumption of yarn is, on the part of 
the yarn itself, not cost, but service. It is the use for 
which the yarn existed. When cloth is turned into clothes, 
this transformation is a service to be credited to the cloth, 
and a cost to be debited to the clothes. AH raw materials 
yield benefits as they are converted into finished products. 
Their conversion is, however, on the part of these prod- 
ucts, always outgo and not income. 

In general, production consists of a succession of stages, 
and at each stage there is an interaction. The finished 
product of one stage passes over as the raw material of the 
next, and its passage from the earlier to the later stage is an 
interaction between the capitals of the two. Each opera- 
tion is credited to the group of instruments earlier in the 
series and debited to the group next later in the series. 



80 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

§ 3. Transportation : Interactions which Change the Posi- 
tion of Wealth 

The second class of interactions we have called " trans- 
portation." It is a very slight distinction which separates 
this class from the preceding class. Transforming or pro- 
ducing wealth consists in changing the position of its parts 
as related to one another; transporting wealth consists 
mechanically in changing the position of that wealth as a 
whole. But " part " and "whole " are themselves loose and 
relative terms. Bookbinding is a transformation or pro- 
duction of wealth ; it assembles the paper, leather, thread, 
and paste into a whole book. Delivering the finished book 
to a library is transportation. Yet the library is, in a sense, 
a whole ; and to assemble books into a classified and organized 
library is to make a whole out of parts and may be regarded 
as a transformation or production of wealth. The distinction 
between transformation and transportation is thus merely 
one of convenience. Many writers prefer to include them 
both under " production." We prefer to include them under 
the less ambiguous and more inclusive head of " inter- 
actions," and our object here is not to emphasize their 
difference but their similarity. The principles already 
discussed of coupling and canceling equal and opposite 
items apply also to transportation. The following are 
examples. When merchandise is transmitted from one 
warehouse to another, the stock in the first warehouse is 
credited with the change and that in the second, debited. 
The stock which has rendered up the merchandise has done 
a service; that which has received it is charged with a 
cost. A banker who takes money from his vault and puts 
it into his till will, if he keeps separate accounts for the two, 
credit the vault and debit the till. When wheat is carried 
from wheatfield to barn the wheatfield is credited and the 
barn debited. When wheat is imported from Canada, 
Canada is credited, and the United States debited. 



Sec, 4] COMBINING INCOME ACCOUNTS 81 

§ 4. Exchange : Interactions which Change the Ownership 

of Wealth 

The third class of interactions is the change of ownership 
of wealth or of property. This has been called "transfer." 
Every transfer is a species of interaction. If two dollars 
are transferred from Smith's cash drawer to Jones's, Smith's 
cash drawer is credited with the two dollars yielded up, and 
Jones's is debited with receipt of the same. Transfers usually 
occur in pairs, and involve two objects transferred in oppo- 
site directions between two owners. One transfer pertains 
to each object. Such a double transfer we have called an 
exchange. Since an exchange consists of two transfers, and 
since a transfer is a species of interaction and as such is self- 
canceUng, every exchange is self-canceling, and hence cannot 
be counted as a part of the total income of society unless it 
be counted out again (although it may lead to later items 
which are not self-canceHng) . Whatever is credited on one 
side is debited on the other. This is shown in the following 
scheme which gives the credits and debits involved when 
goods worth $2 are sold. The dealer credits his stock of 
goods and debits his " cash," while the buyer does the 





Stocks or Goods 


Stocks of Cash 


Seller's 

Buyer's 


Cr. $2 
Dr. $2 


Dr. $2 
Cr. %2 



opposite. We see, then, that an exchange, whether of 
goods against goods or of goods against money, occasions 
an element of income to the seller equal to the corre- 
sponding element of outgo to the purchaser, and an element 
of outgo to the seller equal to the corresponding element of 
income to the purchaser, and therefore no immediate in- 
come at all to society. 

G 



82 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

The effect of canceling these items — the credit item of 
the seller and the debit item of the purchaser — is to free 
the income account for any article from all entanglements 
with exchange, to wipe out all money-income, and to leave 
exposed to view the direct or natural income from that 
article. Thus books yield their natural income, not when 
the book dealer sells them, but later when the reader 
peruses them. The sale is a mere preparatory service, a 
credit item to the book dealer, and a debit item to the 
buyer. Only the book remains in the hands of the pur- 
chaser. Again, a forest of trees yields no natural income 
until the trees are felled and pass into the next stage of logs. 
The owner of the forest may, to be sure, " realize " on the 
forest long before it is ready to be cut, by simply selling it to 
another. To the seller the forest has then yielded income ; 
but, as the purchaser has suffered arl equal outgo, the net 
result of this interaction, as of every other, is zero. 
Only the forest remains ready for future use. Similarly, 
the money " rent " of a rented house is, for society, not 
income at all. It is income to the landlord, but outgo 
to the tenant — outgo which he is willing to suffer solely 
because of the shelter he receives. As we may cancel the 
landlord's money-income against the tenant's money-outgo, 
it is clear that the shelter alone remains as the income from 
the house. The shelter-income is the essential and abiding 
item, and without it there could be no rent-income to the 
landlord. Thus we see clearly the fallacy of the old view 
that a dwelling yields income only when it is rented. In 
like manner, a railway yields as its natural income solely 
the transporting of goods and passengers. Its owners sell 
this transportation service for money, and regard the rail- 
way simply as a money-maker ; but to the shippers and pas- 
sengers this same money is an expense, and exactly offsets 
the railway's money earnings. Of the three items — 
money-income of the road, money-outgo of its patrons, and 
transportation — the first two mutually cancel and leave only 



Sec. 4] COMBINING INCOME ACCOUNTS 83 

the third, transportation, as the real contribution of the 
railway to the sum total of income. 

We do not mean, of course, that interactions are useless, 
but simply that in the accounting of society they are self- 
canceling. They are a necessary step toward achieving the 
final income which remains uncanceled, but they themselves 
disappear under the method of couples. We see that 
capital is not a money-making machine, but that its income 
to society is simply its services of production, transporta- 
tion, and gratification. The income from the farm is the 
yielding of its crops; from the mine, the giving up of 
its ore ; from the factory, its transformation of raw into 
finished products ; from commercial capital, the passage of 
goods between producer and consumer ; from articles in con- 
sumers' hands, their enjoyment or so-called " consumption." 
Although these items are all measured in terms of money, 
they do not consist of money receipts. Those items which 
do consist of money receipts are money receipts for in- 
dividuals, never for the world as a whole ; since each dollar 
received by one person implies that some other person — 
the one from whom it was received — expended it. 

Similar principles apply to outgo, no part of which, for 
society, occurs in money form. The great bulk of what 
merchants call " cost of production," expense, or outgo, 
consists of money costs which, as concerns society, carry with 
them their own cancellation, and so are not ultimate costs 
at all. For manufacturers, merchants, and other business 
men, almost every outgo is an expense, i.e., consists of a 
money payment. But such money payments are for 
wages, raw materials, rent, and interest charges, all of which 
are incomes for other people. The wages are the earnings 
of labor ; the payment for raw material is received by some 
other manufacturer, farmer, or miner ; the rent is received 
by the landlord; the interest charges, by the creditor. 
Labor itself — human effort, not the payment for it — re- 
mains, however, uncanceled. 



84 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. V 

§ 5. Accounts Illustrative of Interactions in Production 

Not only do money transactions completely cancel them- 
selves out in reckoning the total income of society, but the 
great majority even of the natural benefits of capital do the 
same. Even these natural benefits of capital consist for 
the most part of " interactions " ; they are transformations 
or transportations of wealth. They are intermediate stages, 
merely preparatory to the final enjoyable benefits of wealth, 
and, after the interactions have been canceled out, do not 
enter as items either on the income or the outgo side of the 
social balance sheet. In order to show the effect of cancel- 
ing out the equal and opposite items entering into every 
interaction throughout all productive processes, let us ob- 
serve the various stages of production which begin with the 
forest above referred to. The gross income produced by 
the forest is the series of events called the turning out of 
logs. This log production is a mere preparatory service, a 
credit item to the forest and a debit item to the stock of 
logs of the sawmill, to which the logs next pass. Next the 
sawmill turns its logs into lumber, and is therefore cred- 
ited with its share in this transformation wliile the lumber 
3^ard is debited with the production of lumber. Intermedi- 
ate categories may, of course, be created, and we may 
follow, in Hke manner, the further transformation, transpor- 
tation, and exchange to the end of the stages of produc- 
tion — or rather, to the ends ; for these stages split up and 
form several streams flowing in different directions. To fol- 
low one only of these streams, let us suppose that the lumber 
which goes out from the yard is used in repairing a certain 
warehouse. The warehouse is used for storing cloth; the 
cloth goes from the warehouse to the tailor ; the tailor con- 
verts the cloth into suits for his customers ; and his cus- 
tomers receive and wear those suits. In this series of 
productive services, all the intermediate services cancel 
out in " couples " and leave as the only uncanceled ele- 



Sec. s] 



COMBINING INCOME ACCOUNTS 



85 



ment, or fringe of final services, the use of clothes in the 
consumers' possession. 

Should we stop our accounts, however, at earlier points in 
the series, the uncanceled fringe at which we should find 
ourselves would be some other item. The uncanceled in- 
come item in a production series is always the positive side 
of some intermediate service or interaction whose negative 
side does not appear, as it belongs to a later stage in the 
series. This will be clear if we put the matter in figures, 
stage by stage. The following are the items for the logging 
camp above mentioned, in the accounts of its owner. 

INCOME ACCOUNT FOR LOGGING CAMP 



Income 



Yielding of logs to sawmill 



50,000 



Outgo 



The income from the logging camp is here seen to consist 
in the production of $50,000 worth of logs. Of course 
there are usually large outgoes ; but as these do not con- 
cern our present point, for simplicity we leave them out 
of account. If we now combine the account of the logging 
camp with that of the sawmill, we shall have accounts like 
the following, in which, to avoid irrelevant compHca- 
tions, no mention is made of any outgoes which do not 
happen to be interactions between the groups of capital 
considered : — 

INCOME ACCOUNT FOR LOGGING CAMP AND SAW- 
MILL 



Capital Source 


Income 


Outgo 


Logging camp . . . 
Sawmill 


Yielding logs to saw- 
mill . . . $50,000 
Yielding lumber to 
lumber yard $60,000 


Receiving logs from 
camp . . $50,000 



86 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 



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Sec. s] combining INCOME ACCOUNTS 87 

In this case, canceling the two log items of $50,000 each, 
we have left only the lumber item ; that is, the net income 
from the combined logging camp and sawmill consists only 
of the production of lumber, their final product. The 
transfer of logs from one department to the other no longer 
appears. This transfer is like the taking of money from 
one pocket and putting it into another — a fact which 
would be particularly evident in case the logging camp and 
sawmill were combined under the same management. 

Extending the same principles to the entire series, we have 
the accounts as given in the table on the preceding page. 

In this table we may successively cancel each pair of 
items constituting an interaction. An item on the left is 
the positive side of an interaction of which the item on the 
right in the line next below is the negative side. Thus, as 
previously, the $50,000 in the first line on the left cancels the 
$50,000 in the second line on the right. Similarly, the two 
items of $60,000 cancel in the two lines next below, to the 
right and left, respectively. If we stop after the first two 
cancellations, thus restricting the account to the first three 
horizontal lines of the table, we shall find that the net in- 
come from logging camp, sawmill, and lumber yard consists 
only of the production of retail lumber, worth $70,000 ; it 
includes neither the transfer of logs from the camp to the mill 
nor the transfer of lumber from the mill to the yard. In 
like manner, if we proceed one stage further, i.e., if we stop 
our cancellations at the end of the first three interactions, 
the production of retail lumber no longer appears as an ele- 
ment of income ; and so on, step by step to the end, when the 
only surviving item will be the " wear " of the suits. 

It is, of course, true that in any actual accounts there will 
be other items besides those which have been exhibited in 
this simple, chainHke fashion. Were it worth while, we 
might insert these additional entries of income and outgo 
elements. Most of them would likewise consist of the posi- 
tive or the negative side of interactions ; and if we were to 



88 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

introduce their respective mates, the opposite aspects of the 
same interactions, it would be necessary to include the 
accounts of still other instruments. If we should follow 
up all such leads, we should soon have, instead of the simple 
chain represented in the table, an intricate network of re- 
lated accounts ; but the same principle of the interaction as 
a self-effacing element would continue to apply. 

§ 6. Preliminary Results of Combining these Income 

Accounts 

The table given will throw light on the question: Of 
what does income consist? or, to be more definite: Of 
what does the income from a particular group oj capital- 
goods consist ? Whether the yielding of logs by the logging 
camp to the sawmill is income or not depends upon what 
capital we are including. It is income with respect to the 
first Hnk of capital in our series (the logging camp) ; it is 
not income with respect to the first two Knks (the logging 
camp and the sawmill taken together), but merely a self- 
canceling interaction between the two. Likewise the use 
of the warehouse is income with respect to the first four 
links of capital, but is not income with respect to the first 
five links. 

We see, therefore, that in reckoning up the income from 
any group of capital we may as well omit all interactions 
taking place within it, and confine ourselves to the outer 
fringe of services performed by the group as a whole. As 
the group is enlarged, this particular outer fringe disappears 
by being joined to the next part of the economic fabric, and 
another fringe still more remote appears. To answer the 
question whether any particular item is or is not income — 
as, for instance, the question, " Is sawing lumber income ? " 
— we must first ask, ^'Income from what? ^^ Income is 
always relative to its source. 

Contrasting the method of couples with the method of 



Sec. 6 



COMBINING INCOME ACCOUNTS 



89 



balances, we may say that the method of couples is useful 
in showing of what elements income consists in any given 
case. The method of balances, on the other hand, is useful 
in exhibiting the amount of income contributed from each 
capital source. The two methods, as applied to the example 
just given, are as follows : — 

(Summarized from Table on p. 86) 
METHOD OF BALANCES 



Capital Income 


Outgo 


Net Income 


Logging camp $ 50,000 

Sawmill . 60,000 

Lumber yard 70,000 

Warehouse 80,000 

Stock of cloth in warehouse 90,000 
Stock of cloth of tailor . . 500,000 
Stock of clothes of customers 600,000 


$ 50,000 
60,000 
70,000 
80,000 
go,ooo 
• 500,000 


$ 50,000 
10,000 
10,000 
10,000 
10,000 
410,000 
100,000 




$600,000 



METHOD OF COUPLES 



Income 


Outgo 


$ JDTaos 




60^1309 _____^ 


t~~5^Z,QOO 


70y©Q» ____ 


6©50QQ 


Sro^seo-- 


fOTQQQ 


§97000 -—___________^ 


■ SS^QQQ 


gesjOSQ^ 


-90,009 


600,000 


—500,000 



The two methods — balances and couples — show the 
same final result ($600,000), but from different points of 
view. By means of the method of balances we are enabled 



QO ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

to see that, of this $600,000, the part contributed by the 
logging camp is $50,000, that contributed by the sawmill, 
$10,000, and so on. By means of the method of couples, 
we are enabled to see that, canceling by the oblique lines, 
we have left but one item, $600,000, representing the 

"wear" of the suits. Thus the entire $600,000 consists of 
the use or "wear" of the suits, although five-sixths of it is 
contributed by other kinds of capital than the stock of 
clothes of customers. Combining the results of both meth- 
ods, we may state that the total net income from the speci- 
fied group of instruments consists of $600,000 worth of 

"wear" of smts, and that this is due partly to the stock of 
clothes and partly to other capital. Of course our table 
does not give all the capital to which the wear of the suits 
is indebted. We have, as already noted, omitted, for the 
sake of simpHcity, all items of cost which do not belong 
to our chosen series. But the inclusion of other items, 
while it complicates the accounts, does not change the 
principle of cancellation. It merely introduces other chains 
of interactions. 

§ 7. Analogies with Capital Accounting 

The two methods correspond in a general way to the two 
methods for canceling liabilities and assets in capital ac- 
counts. Applied to capita], the method of balances gave, 
it will be remembered, the amount of capital belonging to 
each individual ; the method of couples showed of what 
elements the total capital consists. Similarly, applied to 
income, the method of balances shows what share of the 
resulting income is contributed by any articles or groups of 
articles of capital; while the method of couples shows 
wherein that resulting income consists. 

Let us consider for a moment the method of couples as 
applied to the two sorts of accounts. In capital accounts 
the self-effacing items were debts ; in income accounts the 
self-effacing items were interactions. These concepts — 



Sec. 7] COMBINING INCOME ACCOUNTS 9 1 

debts and interactions — supply the key for the mutual 
cancellations between accounts. A debt is both positive 
and negative • and so is self-canceling. An interaction is 
likewise both positive and negative and so self-canceling. 
A realization of the two-faced nature of debts helps us to 
avoid the confusions of double counting in capital accounts 
and double taxation ; a realization of the two-faced nature 
of interactions saves the confusions of double counting in 
income accounts. 

It is important here to observe of income, as was pre- 
viously observed of capital (Chapter III, § 8) , that the self- 
effacement of the self-effacing elements (interactions in 
the case of income) does not mean that the total income 
would be just the same if there were no interactions. On 
the contrary, the existence of interactions — the operations 
of industry and commerce — are essential steps toward the 
final goal of uncanceled income to which they lead. 
Without them the final uncanceled income would be very 
much less and often nonexistent. Debts mean subdivided 
ownership of capital and interactions mean subdivided 
steps in income. They make capital and income respec- 
tively more abundant and effective. 

We may illustrate what has been said by two simple 
examples. If a man owns a piece of real estate worth 
$10,000 and mortgages it for $6000, this debt must be 
entered in his accounts as a liability of $6000 and in the 
accounts of the mortgagee as an asset of $6000. Conse- 
quently, as between the two men the item cancels out. 
But this does not mean that the mortgage is of no ac- 
count. It does not mean that the two men would be just 
as well off if there were no mortgage. If we should force 
them against their vnl] to cancel the debt, it would be an 
inconvenience to both. The owner would find it difficult 
to make the payment and the mortgagee would have the 
inconvenience of finding another investment for the $6000 
returned to him. The inconvenience to the owner might 



92 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap, V 

be SO great that he would be forced to sell his land per- 
haps at a sacrifice below the $10,000 which is its real 
worth, while if the mortgage is allowed to stand, he might 
not be willing to sell even for a sum considerably above 
the $10,000. The inconvenience to the mortgagee might 
be less. 

We find the same thing true of interactions. A book- 
seller who sells $2000 worth of books in the course of a 
year credits his business with this sum while his customers 
debit their libraries with $2000 worth of books. These 
entries are evidently correct accounting, and the receipts 
of the bookseller and the expenditures of his customers 
exactly offset each other. But this does not mean that 
the transactions are of no account. Without them the 
bookseller would find a great accumulation of books which 
would be entirely useless to him while his customers would 
be deprived of the satisfaction of reading these books. If 
we could force the reversal of the normal process and 
make the customers resell their books to the dealer, there 
would be an obvious loss to both parties. The dealer 
would refuse to take them except at a price far below the 
$2000, while their possessors would not be willing to sell 
them unless for more than $2000. 

§ 8. Double Entry in Accounts of Fictitious Persons 

We have now followed the cancellations to which inter- 
actions lead, whether they be interactions of exchange or of 
production. The case of exchange, however, needs further 
consideration. Since every exchange consists of two trans- 
fers, and every transfer of two items, a credit and a debit, 
the exchange evidently consists of four items in all, two of 
which are credits and two of which are debits. These four 
may be paired off in two ways, only one of which has thus far 
been mentioned. They stand, as it were, at the four corners 
of a square, as in the scheme given in § 4. 



Sec. 8] COMBINING INCOME ACCOUNTS 93 

The two transfers into which any exchange may be re- 
solved are represented by the second and third columns of 
that scheme.- The second column indicates that a $2 
article has been transferred from the stock of the seller to 
that of the buyer, being, therefore, credited to the one and 
debited to the other ; the third column indicates that $2 
of money has been transferred from the stock of cash of 
the buyer to that of the seller and credited and debited 
accordingly. But this same exchange may also be resolved 
into two pairs of items represented by the two horizontal 
lines of the scheme. The upper line indicates that the 
seller has exchanged goods for cash crediting his goods 
with the sale and debiting his cash ; the lower line indi- 
cates the reverse conditions for the buyer. 

Every exchange, then, consists of four items, and may be 
resolved either into two transfers (one for each good ex- 
changed) or into two transactions (one for each person 
exchanging those goods). 

These latter items, namely, transactions represented by 
the horizontal Hnes, we must now consider more fully. 
Each of the previous income accounts is an account of in- 
come flowing from a specified good owned, not of the entire 
income received by a given person as owner. But it is easy 
now to form the income accounts of any given person, i.e., 
the income and outgo of all his assets and Habilities, simply 
by combining in each case, by the method of balances, the 
accounts of all his items of property (whether assets or lia- 
bilities). We must distinguish, however, the accounts of 
real and of fictitious persons. We begin with the income 
account of a fictitious person. 

The following account represents the entries during a given 
year for a dry goods company. In this account we observe 
that every item on the income side is balanced by an equal 
and opposite item on the outgo side. All items thus paid 
are represented by the same letters, the capitals being 
used for positive items and the small letters for negative. 



94 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 



INCOME AND OUTGO OF A DRY GOODS COMPANY 
FOR 1910 



Capital Source 


Income 


Outgo 


Stock of goods 


By goods sold $10,000 A 


To goods bought $5,000 b 


Cash .... 


By cash taken out 
for purchases $5,000 B 
for profits $2,000 C 


To cash received 

from sales . . $10,000 a 


Capital Stock . 
(a liabiUty) 




To dividends $2,000 c 



The rule we have learned in Chapter IV for making com- 
plete income accounts is to start with the capital account, 
taking each item of assets and each item of liabilities, and to 
enter for each item of either kind all the items of income to 
which they give rise, plus or minus, as the case may be. 
For simplicity, it is here assumed that, instead of fifty or one 
hundred different items of capital, there are only three items ; 
namely, the stock of goods, the stock of cash, and the " capi- 
tal stock," which is " negative capital." The stock of goods 
yields $10,000 worth of sales. But, on the other hand, it 
costs $5000 to replenish this stock of goods. Therefore it is 
credited with a plus item of $10,000, and debited with a 
minus item of $5000. The student will notice, moreover, 
that each of these items is entered twice, once on each side. 
The doubly entered items may be mutually canceled. A 
cancels with a ; that is, though the stock of goods is credited 
with bringing in $10,000 (A) in cash, the cash drawer must 
be debited with the $10,000 (a) which it swallows up. Like- 
wise the stock of goods costs $5000 (b) , which must therefore 
be debited to it ; but the cash drawer has to supply this 
$5000, and is therefore credited with $5000 (B) , so that items 
B and b cancel. Finally, when the profits are paid, they 
also come out of the cash drawer, and the cash drawer is 



Sec. 9] COMBINING INCOME ACCOUNTS 95 

credited with exactly that amount, $2000 (C) ; while the 
" capital stock '' is debited with that amount as a cost (c). 
So we see that all six items cancel one another in pairs. 
The two sides of the account of such a fictitious person 
necessarily balance. Even if the company accumulates its 
profit instead of paying it in dividends to the shareholders, 
the two sides of its account still balance ; for, as has been 
seen, all money received is not only credited to the capital 
source which brought it in, but is also debited to the cash 
account. Here, for instance, the $2000 item (doubly entered 
as C and c) would merely be omitted. There would be no 
$2000 dividends, but the cash drawer would be $2000 
fuller. 

§9. Double Entry in Accounts of Real Persons 

In the case of real persons, however, the two sides do not 
balance, for the accounts do not then consist solely of double 
entries. To show this, let us consider the accounts of a 
real person as given in the next table. In these accounts, as 
in the previous ones, both of which are much simplified, 
we have indicated the like items on opposite sides by hke 
letters, the positive items being represented by capitals and 
the negative by small letters. We observe that, as in the 
accounts of the previous company, many of the items will 
" pair," But, unlike the company's accounts, the present 
accounts contain a residue of items which will not pair. 
The letters representing these unpaired items are designated 
on the next page by being inclosed in square brackets. 
They show that [B] and [C] — the shelter of the house, and 
the use of food — constitute a kind of income which does 
not appear elsewhere as outgo. 

When studying the accounts of goods owned, we found in 
considering the chain of productive services of a lumber 
camp, etc., that there always remains some outer fringe of 
uncanceled income. We have now reached this same kind 



96 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 



INCOME AND OUTGO OF A REAL PERSON FOR THE 
YEAR 1910 



Capital Source 


Income 


Outgo 


Stocks and bonds 


By receipt of money from 


To money expended 




stocks and bonds $2000 A 


for stocks and 


- 




bonds . $500 d 


Lease right . . 


By shelter . . . $100 [5] 


To money rent 
paid . . $100 e 


Food .... 


By use of food . .$iso[C] 


To money cost of 
food , . $150 / 


"Cash" . . . 


By cash taken out for 


To receipt of money 




stocks and bonds $500 D 


from stocks and 
bonds . I2000 a 




By payment for rent $100 E 


To receipt of 
money for work 
done . $2000 g 




By payment for food $150 F 




Self .... 


By receipt of money for work 
done .... $ 2000 G 





Uncanceled items : Shelter [B] . . $100 

Use of food [C] . $150 

Total uncanceled income . . . . $250 



of outer fringe in studying the accounts of owners, provided 
they are real persons. This outer fringe consists of the 
final benefits of their goods. All other items are merely 
interactions preparatory to such final benefits, and pass 
from one category of capital to another. Thus the in- 
come from investments, being paid into the cash drawer, is 
outgo with respect to the drawer ; the drawer yields income 
by paying for stocks and bonds, food, etc., but in each case 
the same item enters as outgo with respect to these or other 



Sec. 9] COMBINING INCOME ACCOUNTS 97 

categories of capital. In all these cases the individual re- 
ceives no income which is not at the same time outgo. It 
is only as he receives shelter from the house, consumes food, 
wears clothes, or uses furniture, or some other article, that 
he receives income. And these final benefits are, of course, 
the end and goal of all the preceding economic processes and 
activities. 

We have thus reached what may be called the stage of 
final or enjoyable income. This is the stage at which wealth 
at last acts upon the person of the recipient. This final 
income is that of which the economist is in search, and is 
that which the ordinary statistics of workingmen's expen- 
ditures represent. It has been made clear that, in the 
final net income v\^hich we derive from wealth, all interactions 
between different articles of wealth drop out — all the trans- 
formations of production, such as the operations of mining, 
agriculture, and industry, all the operations of transportation, 
and all transfers and exchanges in business. For in all such 
cases the debits and credits inevitably occur in pairs of equal 
and opposite items. Each pair consists of the opposite facets 
of the same interaction. The only items which survive are 
the final personal uses of wealth. The chief classes of such 
uses or benefits are those of nourishment, shelter, and 
clothing. 

Having reached the action of wealth on the human 
body, we may, as students of economics, be content to 
stop. But, theoretically, there is one step more before 
the process of tracing a series of interactions has reached 
its final goal. Indeed, no benefits outside ourselves 
are of significance to us except as they lead to feelings 
within our minds. And if we regard the human body in 
the same light in which we have regarded articles of 
wealth, we could extend our accounts by conceiving wealth 
as interacting with the human body. We would then 
debit the human body with the nourishment, shelter, pro- 
tection from cold, etc., which it receives from food, dwellings, 



98 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. V 

clothing, etc., and credit it with the satisfactions experienced 
through the brain, i.e., the feehngs of enjoyment of food or 
avoidance of pain, etc. As, however, we have in general, 
in this textbook, limited the concept of wealth to its nar- 
rower definition, excluding free human beings, we shall not 
attempt to follow these transformations of income after 
they reach the person of the owner. Usually the mental 
satisfactions follow so closely after the physical effects of 
wealth on the human body that practically we scarcely 
need to distinguish between those physical effects and the 
resulting satisfactions. Hereafter we shall speak of satis- 
factions of food, shelter, clothing, etc., as if they flowed 
directly from these external objects. 

§ 10. Ultimate Costs and Income 

We have now reached a convenient place at which to 
emphasize a point of great importance, but one which is 
seldom understood; namely, that most of what is called 
*' cost of production " is, in the last analysis, not cost at all. 
We have found, in using the method of couples, that every 
item of money cost is also an item of income, and that in 
the final total no such items survive cancellation. It costs 
the baker flour to produce bread ; but the cost of flour to 
the baker is a benefit to the miller. To society as a 
whole, on the other hand, it is neither cost nor benefit, 
but a mere interaction. 

As has been said, in the last analysis, payments of 
wages, interest, rent, or any other payments from one mem- 
ber of society to another, are not costs to society as a whole. 
This fact should now be clear ; yet it is commonly over- 
looked. When people talk of the cost of producing coal or 
wheat, they usually think of money payments. The items 
called costs of production are mostly payments from per- 
son to person, or interactions, at various stages of produc- 
tion. We have seen that each such item is two-faced and, 



Sec. io] combining INCOME ACCOUNTS 99 

in the final total, wipes itself off the slate. The only ulti- 
mate item of cost is labor cost or efforts ; that is, all the 
experiences of .an undesirable nature which are undergone 
in order that experiences of a desirable nature may be 
secured. We may conclude, therefore, that in the last 
analysis income consists of satisfactions and outgo of efforts 
to secure satisfactions. Between efforts and satisfactions 
may intervene innumerable interactions, but they all must 
cancel out in the end. They are merely the machinery 
connecting the efforts and satisfactions. At bottom, eco- 
nomics treats simply of efforts and satisfactions. This is 
evident in the case of an isolated individual like Robinson 
Crusoe, who handles no money; but it is equally true of 
the most highly organized society, though obscured by the 
fact that each member of such a society talks and thinks 
in terms of money. 

In the light of the foregoing principles we are now in a 
position to take a bird's-eye view of the income of any coun- 
try. Unfortunately, there are no available statistics for 
income in the United States. We can only guess as to what 
the amount of it may be. Possibly $20,000,000,000 worth 
of final income is annually enjoyed in the United States, 
of which about one third is in the form of nourishment or 
food uses, about one sixth in the form of shelter, and 
about one eighth in the form of clothing. These and 
the other items of the direct uses of wealth constitute the 
real income of society. In other words, our real income is 
what is often called our " Hving." Money-income, as we 
have seen, is not real income, but is converted or spent for 
real income in what we caU our " bread and butter," 
which, more exactly expressed, means the use of our 
" bread and butter " and of the other goods contributing 
direct benefits to human beings. These uses include the 
necessaries, comforts, luxuries, and amusements of life. 
These are what make up our " living." The more money 
wages it costs to acquire a given amount of real wages. 



100 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. V 

the higher the "cost of living" of which we hear so much 
to-day. The money which the workman is paid in wages 
is not his real wages, but only his nominal wages. The 
real wages are the workman's Uving for which that money 
is spent. Money payments, as we have seen, cancel 
themselves out when we take a view of the whole, for they 
are not only receipts, but also payments. They there- 
fore disappear, just as in our view of capital the bonds 
and stocks disappear, being not only assets, but also liabili- 
ties. And in exactly the same way the operations of pio- 
duction and transportation cancel themselves out in the 
total production of the farms. The ten billions of dollars' 
worth of farm products, for instance, which we are produc- 
ing are not a part of the income of the country to be added 
to our consumption of food, etc., any more than they are 
a part of the costs of the country. To the farmer they 
represent income, but to those who buy of the farmer they 
represent outgo, while to the country as a whole they rep- 
resent neither income nor outgo. By the method of couples 
they vanish, and in their stead we have the consumption of 
bread and the other finished products which originated with 
the farm ; and should we, as is sometimes erroneously 
done, try to add together the value of these finished products 
and the value of the farm products, we should be guilty of 
double counting, as would be the case in capital accounting 
if we should add the value of mortgages to the value of 
real estate. 

The method of couples thus provides us with a view of real 
income, making clear what it consists of and what it does 
not consist of. If, however, we wish to know the extent to 
which various agencies have produced this income, we must 
look at the matter from the standpoint of the method of 
balances. From this standpoint, perhaps three quarters of 
the total income enjoyed in the country is produced by 
human beings, the workers of society, the remainder being 
produced by capital in its narrower sense. Of this capi- 



Sec. io] combining INCOME ACCOUNTS lOI 

tal that which produces the greater part of our income is 
land, but some of our income must also be credited to 
railways, shipsj factories, shops, dwellings, etc. It does 
not matter whether the capital is or is not itself the prod- 
uct of other capital, of human beings, or of nature. 
There will usually be a net income to be credited opposite 
each kind of capital, as shown in the table of the Method 
of Balances in S 6. 



CHAPTER VI 

CAPITALIZING INCOME 

§ I. The Link between Capital and Income 

We have now learned what capital and income are, and 
how each is measured. We have seen that the term " capi- 
tal " is not to be confined to any particular part or kind of 
wealth, but that it applies to any or all wealth existing at a 
given instant of time, or to property rights in that wealth, 
or to the values of that wealth or of those property rights. 
We have seen that income is not restricted to money- 
income, but that it consists of all kinds of benefits of wealth. 
We have seen that, like capital, income may be measured 
either by the mere quantity of the various benefits or by the 
value of those benefits. We have seen that in the addition 
both of capital-value and of income-value there are two 
methods available for canceling positive and negative items, 
called respectively the " method of balances " and the 
" method of couples." By the method of balances the nega- 
tive items in any individual account are deducted from the 
positive items in the same account, and the difference or 
" balance " gives the net capital (or income, as the case 
may be) with which that account deals, whether this net 
capital (or income) pertains to a particular instrument or 
instruments, or to all the property of a particular owner. 
The method of couples, on the other hand, cancels items in 
pairs and is founded on the fact that, as to capital, every 
liability relation has a credit as well as a debit side — 



Sec. i] capitalizing INCOME 103 

namely, as related to creditor and debtor respectively ; and 
that, as to income, every interaction is at once a benefit and 
a cost — a benefit occasioned by that good (or person) by 
which the event originates ; a cost occasioned by that good 
(or person) for which it originates. 

We observed that it is the method of couples alone which, 
if fully carried out, reveals wherein capital and income 
ultimately consist. This method, appHed to capital, gradu- 
ally obliterates all partial rights, such as stocks and bonds, 
and exposes to view the concrete capital-wealth of a com- 
munity. The same method appHed to income obhterates 
the "interactions" such as money payments between 
persons, and exposes to view an uncanceled outer fringe of 
benefits and costs. It leaves simply the final benefits of the 
wealth, poured, so to speak, into the human organism — 
the satisfactions and the efforts of human life. 

We have seen that capital and income are in many re- 
pects correlative ; that all capital yields income and that 
all income flows from capital including human beings. 

In spite of this close association between them, capital 
and income have thus far been considered separately. The 
question now arises : How can we calculate the value of 
capital from that of income or vice versa ? The bridge or 
link between them is the rate of interest. The rate of interest 
is the ratio between income and capital, both the income and 
the capital being expressed in money value. Business men, 
therefore, sometimes call the rate of interest the "price of 
capital " or the " price of ready money." Suppose, for 
instance, that a merchant wants a capital worth $10,000 and 
is willing to pay a bank $400 per year for it perpetually ; 
then the price the merchant pays for the capital (or the ratio 
between the annual payment to the bank and the capital 
received from it) is $400 -r- $10,000 = y^, or four per cent, 
and the rate of interest is, therefore, said to be four per cent. 

We may also define the rate of interest as the premium 
on goods in hand at one date in terms of goods of the same 



I04 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

kind to be in hand one year later. Present and future goods 
seldom exchange at par. One hundred dollars, if in hand 
to-day, is worth more than if due one year hence. To-day's 
ready money will always buy the right to more than its full 
value of next year's money. If, then, $ioo to-day will ex- 
change for $104 to be received one year hence, the premium 
— or rate of interest — is four per cent. That is, the price 
of to-day's money in terms of next year's money is four per 
cent above par ; for $104 -^ $100 exceeds $100 -7- $100 by 
-^^-^, which is four per cent. 

We have, then, two definitions of the rate of interest, 
viz., " the price of capital in terms of income " and *" the 
premium which present goods command over similar goods 
due one year hence." 

But the two definitions are quite consistent, and either defi- 
nition may be converted into the other. The rates of interest 
in the two senses are, in fact, normally equal. For instance, 
if a man borrows $100 to-day and agrees to pay it back in 
one year with interest at four per cent, we may conceive of 
him as selling for $100 a perpetual income of $4 a year — • 
and at the same time agreeing to buy it back for $100 at the 
end of one year. But these two stipulations — to sell and 
to buy back — amount simply to an exchange of $100 
to-day for $104 next year — i.e., an exchange of present for 
future money at four per cent. Thus the rate of interest in 
the price sense becomes equivalent to the same rate in the 
premium sense. Or, beginning at the other end, conversely 
if we suppose $100 to-day to be exchanged for $104 due 
one year hence, so that the rate of interest in the premium 
sense is four per cent, we may suppose that when the time 
comes to receive the $104, only $4 of it is really kept, the 
$100 being again exchanged for $104 due the year follow- 
ing. If this process is repeated indefinitely, the man will 
continue to receive simply $4 a year ; and thus the rate of 
interest in the premium sense becomes equivalent to the 
same rate in the price sense. 



Sec. i] capitalizing INCOME I05 

By means of the rate of interest we can evidently translate, 
as it were, present money-value into its equivalent future 
money-value, or future money-value into its equivalent 
present money-value. To translate any present value into 
next year's value, when interest is four per cent, we multiply 
this year's value by the factor 1.04; to translate any next 
year's value into this year's value, we divide next year's 
value by the factor 1.04. Thus if the rate of interest is 
four per cent, I25 to-day is the equivalent of $25 X 1.04 due 
one year hence, i.e., $26. Or, vice versa, $26 due one year 
hence is worth in the present $26-^1.04, or $25. Again, 
$1 due one year hence is worth in the present $1 -^ 1.04, 
or $0,962. In general we may obtain the present worth of 
any sum due one year hence by dividing that sum by one 
plus the rate of interest. This latter operation is what we 
learned in our school arithmetics as " discounting," by which 
is meant finding the "present worth " of a given future sum. 
The rate of interest is thus a link between values at any 
two points of time — a link by means of which we may 
compare values at any different dates. 

The rate of interest, however defined, may be regarded as 
a species of price ; but it is a very different species from any 
prices mentioned in previous chapters. We have seen that 
the price of wheat enables us to translate any given number 
of bushels of wheat into so many dollars' worth of wheat; 
and the prices of other goods in like manner, to translate 
their respective quantities .into their money equivalents. 
Any price thus serves as a bridge or link between the quan- 
tity of any good and its value in some other good, as money. 
By means of prices we can convert a miscellaneous assort- 
ment of goods at any time into their money-value for that 
same time, or convert a miscellaneous assortment of benefits 
occurring through a period of time into their money-value 
for that same period. By such prices we may only convert 
quantities into simultaneous money-values. We cannot, by 
them, pass from one time to another. By means, however, 



I06 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

of that unique price called the rate of interest, we may 
convert the money-values found for one time into their 
equivalent at another time. The rate of interest is thus the 
hitherto missing link necessary to make our reckoning of 
money equivalents universal. 

We are not yet ready to explain how the rate of interest 
comes about. In fact, we are not yet ready to explain how 
any prices come about. We must, for the present, take 
the rate of interest ready-made, as it were, just as we have 
taken other prices ready-made. In the preceding chapters 
we have seen how to form capital accounts and income ac- 
counts by assuming the prices necessary in each case to turn 
quantities into money-values. We are now ready, by as- 
suming a rate of interest, to show the relations between these 
two sets of accounts — i.e., to turn income into capital. It 
is worth while, however, at the outset to rid our minds of the 
idea that money is the one and only source of interest, just 
as we have already rid our minds of the idea that money is 
the only kind of wealth. We may, as we have seen, express 
a great many things in terms of money-value which are not 
themselves money. This habit leads us unconsciously into 
the fallacy of thinking of these things as though they were 
actual money. If we question a man who says, " I have 
$10,000 of money invested, and from it I get $500 of money 
each year as interest," implying a rate of interest of five per 
cent, he will be forced to admit that he has not really got 
$10,000 of money at all, and, perhaps, even that the $500 of 
money interest which he says he gets each year is not at 
first in money form. The true form of statement is simply 
that he has a farm (or other capital-wealth) which yields 
crops (or other products), and that both of these may be 
measured in terms of money, the farm being worth $10,000 
and the crops $500. Money need not enter at all except as 
a matter of evaluating in bookkeeping. Hence, if we are 
careful, we shall avoid thinking and speaking of a fund of 
$10,000 producing an interest of $500, but will instead think 



Sec. 2] CAPITALIZING INCOME 107 

and speak of actual capital, such as farms, factories, rail- 
ways, or ships, worth $10,000 a,nd producing actual benefits 
(such as yielding crops, manufacturing cloth, or transporting 
goods) which are worth $500. 

There is another confusion to be carefully avoided, viz., 
the confusion between interest and the rate of interest. If 
the interest from $10,000 worth of capital is $500 worth of 
benefits, the rate of interest is five per cent. Interest and 
the rate of interest are as distinct as value and price and in 
the same way. 

The rate of interest, then, is a sort of universal time price 
representing the terms on which men consider this year's 
values exchangeable in next year's or future years' values. 
By assuming this rate, we are enabled to convert future values 
into present, and present values into future. 

§ 2. Capital as Discounted Income 

But although the rate of interest may be used either for 
computing from present to future values, or from future to 
present values, the latter process is far the more important 
of the two. Accountants, of course, are constantly comput- 
ing in both directions, for they have both sets of problems to 
deal with ; but the problem of time valuation which nature 
sets us is that of translating the future into the present; 
that is, the problem of ascertaining the value of capital. 
The value of capital must be computed from the value of its 
expected future income. We cannot proceed in the opposite 
direction and derive the value of future income from the 
value of present capital. 

This statement may at first puzzle the student, for he may 
have thought of income as derived from capital, and, in a 
sense, this is true. Income is derived from capital- goods. 
But the value of the income is not derived from the value of 
those capital-goods. On the contrary, the value of the 
capital is derived from the value of the income. These re- 



Io8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

lations are shown in the following scheme in which the 
arrows represent the order of sequence — from capital- 
wealth to its future benefits, from its benefits to their 
value ; and from their value back to capital- value : — 

Capital-wealth — >- Flow of benefits (income) 

Capital-value -< — Income-value 

Not until we know how much income an item of capital 
will bring us can we set any valuation on that capital at 
all. It is true that the wheat crop depends on the land 
which yields it. But the value of the crop does not depend 
on the value of the land. On the contrary, the value of 
the land depends on the value of its crop. 

The present worth of anything is what men are willing to 
give for it. In order that each man may decide what he is 
willing to give, he must have : (i) some idea of the value of 
the future benefits his purchase will bring him, and (2) some 
idea of the rate of interest by which these future values may 
be translated into present values by discounting. 

With these data he may derive the value of any capital 
from the value of its income by means of the connecting 
link between them called the rate of interest. This deriva- 
tion of capital- value from income-value is called " capi- 
talizing" income or " discounting " income. 

§ 3. The Discount Curve 

Let us assume that, for any given article of wealth or 
property, the expected income is foreknown with certainty, 
and that the rate of interest is also known. With these pro- 
visos, it is very easy, by the use of the rate of interest, to 
compute the capital-value of said wealth or property ; and 
this, whether the income accrues continuously or discon- 
tinuously; whether it is uniform or fluctuating; whether 
the installments of it are few or infinite in number. 



Sec. 3] CAPITALIZING INCOME IO9 

We begin by considering the simplest case ; namely, that 
in which the future income consists of a single item becoming 
due at some particular time. If, for instance, one holds a 
property right by virtue of which he will receive at the end 
of one year a benefit worth $1.04, the present value of this 
right, if the rate of interest is four per cent, will be $1. Or if 
the future benefit one year hence is worth $1, its present 
value (interest being at four per cent) is found, as we have 
seen in §1, by dividing the $1 by the factor 1.04. The 
result is $1 -j- 1.04, or $0,962. If the value to which the 
right entitles the owner is any other amount than $1, its 
present value is simply that given amount divided by 1.04. 
Thus the present value of $432 due in one yeai is 
$432 -^ 1.04, which is $415.38. 

Let us now take a period of two years instead of one. We 
know by " compound interest " (at 4 per cent) that not only 
will $1 amount to $1.04 next year, but that this $1.04 next 
year will amount to $1.04 X 1.04 or $1,082 the year after, — 
in short, that $1 to-day amounts in two years to $1 X (1.04)^ 
or $1,082. Conversely, of course, the sum of $1,082 due two 
years hence is worth in present value $1,082 -f- (1.04)^, or $1. 
Similarly, the present value of, let us say, $1000 due two 
years hence is $1000 -r- (1.04)^ or $924.21. We see then that, 
if interest is 4 per cent, we can, by multiplying by (1.04)^, 
translate any present sum into its equivalent two years 
hence, and we can, by dividing by (1.04)^, translate any 
sum due two years hence into its equivalent present value. 

By the same reasoning it is easy to show that we must 
multiply any sum in hand to-day by (1.04)^ to obtain the 
equivalent sum due three years hence, and must divide 
any sum due three years hence by (1.04)^ to obtain its 
present value. If the period is four years, we must multi- 
ply or divide by (1.04)^; for five, by (1.04)^, etc. For our 
present purposes we shall need to apply the process of divi- 
sion by (1.04) or (1.04)^ or (1.04)^, etc. ; for our chief object 
is to translate future sums into present, not the reverse. 



no 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 



We may illustrate this process by a diagram, much in the 
same way as geography is illustrated by a map. Curves 
sometimes puzzle beginners, but they are very important 
in economics, and render the subjects which they illustrate 
so clear and simple that the student should not fail to make 
himself master of their use at the outset. 

In Figure 3 the vertical distances measure the money 
and the horizontal distances measure the lapse of time. 
The sum of $100 (represented as hB) is supposed to be 
due at the beginning of the year 1901. The problem is 
to find its value at the point of time represented by a ; 
that is, at the beginning of the year 1900, which we 
shall consider the "present instant" or simply the "pres- 
ent." This discounted value is a A. If we draw the line 
BA, its slope downward from right to left pictures the fact 
that a future sum becomes smaller and smaller in present 

value the longer the period of 
time involved. This line BA is 
called the discount curve. It is 
not a straight line, but a line such 
that its height at any point rep- 
resents the discounted value of 
hB for the particular instant cor- 
responding to that point. If the 
$100 due in 1901 be discounted 
in 1900 at four per cent, its value 
in the latter date will be $96.15, 
the difference in value between 
the two points of time being 
$3.85, as indicated in the dia- 
gram, where aC is equal to hB, and AC is the difference 
between aC or hB, the amount due in 1901, and a A, the 
discounted value of that amount in 1900. 

We shall understand the nature of this curve better if, 
instead of taking merely the interval of one year, we con- 
sider a longer interval such as ten years. This is represented 



3.85^^ 
96.1 S'go 

80 

70 
60 
SO 
40 
30 

ao 

10 

a' 



-100 



I900 1901 

Fig. 3. 



Sec. 3] 



CAPITALIZING INCOME 



III 



in Figure 4. In this figure, as in the preceding figure, the 
vertical distances (or "latitudes") above the base line 
represent sums -of money and the horizontal distances (or 
" longitudes ") represent periods of time. The curve, 
ABC DM is the discount curve. The latitudes of these 
points (or their vertical distances above the base line, abcdm) 
represent the values of the same capital-good at different 
instants of time ; and the longitudes or horizontal distances 
between them represent the intervals of time between those 



(-50 



K50 
1.40 
1.30 


H 








































M 


\ 




































,^ 


































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\X30 
SO 
.60 
.70 
.60 
SO 

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30 
.20 
.10 
.00 






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-- 




— 


— 


-- 


— 


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— 


— 


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- 


- 




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— 


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a. 




b,. 




c 




d 




























m 



1 900 01 * 'OS '03 '04 '05 *05 '07 'OS '09 '10 

Fig. 4. 



instants. Thus, let the point a represent the present 
instant, say the beginning of the year 1900, and let the 
longitude interval, ah, represent a year, say from the be- 
ginning of 1900 to the beginning of 1901. Using equal 
intervals for successive years, we have aA representing any 
capital-value at the beginning of the year 1900, say $1, hB 
representing its equivalent next year, say $1.04, cC, the 
equivalent two years hence, and so on. We see that hB is 
what we have called the " amount," $1.04, of a A put out 
at interest for one year, and cC is the "amount" of the same 



112 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

compounded for two years. Conversely a A represents the 
present value in 1900, or discounted value, of any one lati- 
tude on the curve, such as bB, as well as of any other, such 
as cC or dD. The latitude of any point on the curve may 
thus be regarded as the " amount " of the sum represented 
by any preceding latitude or as the "present value" of the 
sum represented by any succeeding latitude. Thus, if the 
total breadth of the diagram am represents ten years, we 
may either say that mM is the amount, at the end of the 
ten years, of the present sum aA, or that a A is the "present 
value " of the future sum, mM, discounted for ten years. 
The line AM not only ascends, but at an accelerating rate 
— i.e., it does not ascend in a straight line, but gradually 
bends upward, being continually steeper toward the right. 
The slope of the curve is due to the rate of interest, and 
the greater the interest in any given period of time, the 
more steeply will the curve slope. This curve, if prolonged 
to the left to show what the " present value " was prior to 
the time a, will, of course, never reach the bottom line. It 
keeps becoming flatter and flatter, so that its distance 
above the line can never become zero. 

If there were no rate of interest or if the rate of interest 
were zero, the curve would not slope at all, but would be 
a horizontal line. 

§ 4. Application to Valuing Instruments and Property 

The principles which have been explained for obtaining 
the present value of a single future sum apply to many com- 
mercial transactions, such as to the valuation of bank assets, 
which exist largely in the form of " discount paper," or short- 
time loans of other kinds. The value of such a note is al- 
ways the discounted value of the future payment to which it 
entitles the holder. Similarly, the value of any article of 
wealth, reckoned when that wealth is in course of construc- 
tion, is the present value of what it will bring when com- 



Sec. 4] CAPITALIZING INCOME II3 

pleted (less the present value of the cost of completion). 
For instance, the maker of an automobile will, at any of its 
stages in the course of construction, appraise it as worth the 
discounted value of the price expected for it when finished 
and sold, less the discounted value of the costs of construction 
and selling which still remain. Thus, if an automobile is to 
be sold for $5000 and requires a year before this sum will be 
realized, while it will cost to complete a sale $2000, which 
sum for simplicity, we also assume is payable at the end of 
the year, the present value of the automobile will be the 
present value of $5000 minus $2000, which, at four per 
cent, will be ($5000 — $2000) -^ 1.04, or $2884.62. The 
element of risk should not, of course, be overlooked ; but 
its consideration does not belong here. 

Another application of these principles of capitalization 
is to goods in transit. A cargo leaving Sydney for Liverpool 
is worth the discounted value of what it will bring in Liver- 
pool, less the discounted value of the cost of carrying it 
there. Another good example is a young forest, which is 
worth the discounted value of the lumber it will ultimately 
form. 

Ordinarily, however, we have to deal, not with one future 
sum, but with a series of future sums. A man who buys a 
bond or a share of stock is really buying the right to a series 
of future items of income. But we can treat a series of items 
of income by discount curves in exactly the same way that 
we can treat one such item. 

For instance, let us consider a $100 '' five per cent " ten 
year bond. Such a bond is simply a promise to pay $5 
each year for ten years and at the end of these ten years 
to pay in addition the "principal" sum of $100. The 
problem is to discover the present value of the bond. This 
is evidently the discounted value of the eleven sums which 
the owner will receive from the bond ; in other words, the 
discounted value of the " principal," due ten years hence, 
together with the discounted values of the ten separate in- 



114 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

terest pa5niients due respectively one year, two years, three 
years, etc., up to and including ten years from date. As 
we have just seen how to get the discounted value of any 
one of these sums, it is simply a question of arithmetic to 
calculate them all and then add them together. Before 
we can perform the calculations, however, we must know 
what rate of interest to use. The mere fact that the bond 
is called a " five per cent " bond does not mean that those 
who buy the bond will calculate its present value to them 
by discounting its benefits at five per cent. The five per 
cent named in the bond is called the nomi?ial rate of in- 
terest. It may or may not be the same as the rate of 
interest used by investors in ascertaining the present value 
of the bond. This latter rate is called the rate " realized." 
If the rate realized happens to be the same as the nomi- 
nal rate of interest, i.e., that named in bond, the present 
value of the bond will be par, or $ioo. This can be shown 
in various ways, as by calculating separately all the eleven 
different sums to which the bond entitles the owner ; namely, 
the ten interest pa3niients of $5 each and the final principal 
of $100. Such a calculation shows that the present value of 
the first interest payment of $5 (namely, that due one year 
hence) is $5 -^ 1.05, or $4.76 ; that the present value of the 
second interest payment of I5 is $5 -4- (1.05)^, or $4.55; 
that the present value of the third interest payment is 
$5 ^ (1.05)^, or $4.32 ; that the present value of the fourth 
interest payment is $5 -^ (1.05)'*, or $4.11 ; and so on up 
to the tenth, the present value of which would be $5 -h 
(1.05)^° or $3.07. To this series must be added the present 
value of the principal, which, being discounted for ten years, 
is $100 -i- (1.05)^°, or $61.39. The sum of all these will be 

$4.76 + $4-55 + S4.32 + $4-11 + $3-92 + 13-73 + $3-55 + 
ts-sS + $3.22 -}- $3.07 -H $61.39 = $100, which is the present 
value of the bond. ^ ^ 

Another method of getting the same result is, beginning 
our calculation at the time when the bond falls due in the 



Sec. 4] CAPITALIZING INCOME I15 

future, to proceed backwards, discounting year by year. It 
is evident that just before the payment of the bond it will 
be worth $105 ;. for at that time there is immediately due 
$5 of interest and $100 of principal. Any time earlier in 
the ninth year, the value of the bond will evidently be 
the discounted value of this $100 and this $5, the discount 
being for whatever portion of the year may be involved. 
Just after the ninth interest payment, and just one year be- 
fore the date when the $105 are due, the value of the bond 
will evidently be found by discounting $105 for one year at 
five per cent. This gives $105 -^ 1.05, or $100. In other 
words, the value of the bond at the end of nine years, just 
after the ninth interest payment, will be par, or $100. The 
instant preceding, namely, just before the ninth interest 
payment, the value of the bond will be more by the amount 
of interest payment, $5. That is, the value of the bond will 
be $105 just before the ninth interest payment and $100 just 
after. This sudden drop of $5 is due to the abstraction of the 
$5 of interest. For this reason, care is always taken by 
brokers at or near the time of interest payments to specify 
whether the bond is to be sold with the interest payment 
or without it, the higher price being paid if the bond is 
bought before the interest has been abstracted. 

Thus, the instant before the ninth payment of interest 
the bond is worth $105, just as was the case the instant before 
the tenth and last payment. By the same reasoning, there- 
fore, its value one year earlier, just after the eighth interest 
payment, will be $100 and just before, $105. In this manner 
we may proceed year by year back to the present, finding 
that the value of the bond will be $100 just after any interest 
pajrment and $105 just before. Its value will therefore be 
$100 just after the first interest payment, which occurs one 
year hence, and $105 just before that payment. The value 
of this $105 at the present instant will therefore be $100. 

Reviewing these figures in the reverse order, we see that 
the value of the bond begins at $100, ascends to $105 one 



ii6 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 



year from date, then drops suddenly to $ioo, ascends during 
the next year to $105, and then drops, and so on, ascending 
and dropping, as it were, by a series of teeth until the whole 
ten years have elapsed, when the value reaches its last 
height of $105 and then disappears altogether. In these 
oscillations, the gradual rise of $5 each year is evidently the 
interest accrued, while the sudden fall of $5 at the end of each 
year is the income taken out. 

It is appropriate, here, to remind the student, that the 
entire height from the base line to any point in this tooth- 













































c 


^ 


^ 


> 


^ 


> 


^ 


^ 


^ 


^ 


^ 


> 


^ 


> 


^ 


> 


^ 


> 


^ 


> 


^5 




N 




































5' 




& 


do 
























































































Rn 
























































































70 
























































































ftO 
























































































Rn 
















































































































































































































































































































































































































































d 


^ 


_a 










- 




5 




5 




5 




- 




- 




5 




5 




5 



M 



4-5 6 

Fig. s- 



A 



like curve — whether at highest or lowest or anywhere 
between — represents the value of the capital at the cor- 
responding instant of time. This should be constantly 
borne in mind. 

The life history of such a bond can best be seen by the aid 



Sec. 4] CAPITALIZING INCOME II7 

of Figure 5. The ten small, dark lines marked "5" stand- 
ing on the base line MA (or the equivalents of these above 
the par line) and the long, dark line AB represent the eleven 
sums to which the bondholder is entitled ; in other words, 
the small, dark lines representing the interest payments 
in the ten successive years, and AB, the principal, $100, 
due at the end of the ten years. The problem is : Given 
these eleven sums to which the bondholder is entitled, to 
show in the diagram the value of the bond at different dates. 
Assuming as before that the rate of interest used in comput- 
ing is 5 per cent, we obtain the results seen in Figure 5. 
We observe that the value of the bond, just before it be- 
comes due, is the sum oi Aa (or BC, $5 of interest), and 
AB (the $100 of principal). This sum is represented by 
the vertical line AC. One year earlier, just after the ninth 
interest payment A' a (or B C'), the value of the bond isA^B', 
or $100, being the discounted value of AC obtained by draw- 
ing the discount curve CB' . The value just before the ninth 
interest payment will be A^C', or $105. Continuing in this 
manner backward, we obtain the series of " teeth," as in- 
dicated in the diagram. 

If the various discount curves in Figure 5 are all continued 
to the left (as in Fig. 6), they will divide the line MN, rep- 
resenting the present value ($100) of the bond, into the 
eleven parts of which it is composed, each part representing 
the present value of one of the eleven payments to which 
the bond entitles the owner. Thus the present value of 
the principal is seen to be $61.39, this being the height 
above M at which the lowest discount curve meets MN; 
the present value of the last or tenth interest payment 
is $3.07, this being the difference in height between the 
two lowest discount curves; the present value of the 
ninth interest payment is $3.22, as indicated in the next 
space above. Similarly, the present value of each of the 
other future payments is indicated in the diagram. The 
parts into which MN is divided thus form a picture 



ii8 



ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. VI 



of the eleven present values calculated earlier in this 
section. 

As we pass from left to right in the diagram, we see that 
the value of the bond at the beginning of each year is 
$ioo, made up of the discounted values of all the remain- 
ing future receipts ; and that the value increases each year 
along a discount curve to $105 at the end of the year, im- 



100 




































c 


b 


1 


^ 


s^ 


^ 


5^ 


^ 


^ 


^ 


^ 


^ 


5- 


^ 


5- 


X 


> 


^ 


5^ 


^ 


^ 


^5 


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"' 




^' 




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, 


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5". 


k" 


B 


90 


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ri 


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AO 






















































































30 


_i 


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SO 






















































































10 














































































d 




a 










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s 




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5 


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s 



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-<?. 5 6 

Fig. 6. 



A" 



mediately before the annual payment is made. The value 
then drops again to $100, when this annual income is 
received. It thus continues to oscillate (just as in Figure 
5) between $100 and $105 each year to the end, when the 
final income of $105 is received. 

But often the bond is not sold at par because the rate of 
interest used by the purchaser in calculating what he is 



Sec. 4] 



CAPITALIZING INCOME 



119 



willing to pay for it may be more or less than the five per 
cent named in the bond ; in other words, the rate realized 
by the purchaser may be more or less than the nominal 
rate. When a bond is sold above par, this fact shows 
that the rate of interest realized by the investor is less 
than five per cent. In this case the bond is only nom- 
inally a " five per cent bond." If the rate used in calcu- 
lating the value of the bond is four per cent, that value 



I08.I7- 

Par 



rar 1 
Valuer 



!O0 
90 
80 
70 
60 
50 
40 
30 
20 
10 





^ 


B^ 


^ 


^ 


^ 


%- 


A^ 


^ 


^ 






















5^ 


■^ 


1^ 




5^ 


^ 


C" 




C 




























^ 


b 




5 




































b 






B 














































































































































































































































































































































































































































































































































































































































































































































































a! 




a 








5 


5 




^ 


\- 




5 




5 




5 




5 


h 




5 



M I 



4- 

FiG. 7. 



8 A A 



will be found to be $108.17 ; so that if the bond is sold at 
$108.17, the purchaser is said to " realize" four per cent. 
It will be seen that the rate realized is that market rate 
which is actually used for discounting eleven items, namely 
the ten annual items of $5 each and the final item of $100. 



I20 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

The value of the bond, $108.17, is found in the way already 
explained and is illustrated by the discount curves in Fig- 
ure 7. Expressed arithmetically the calculation consists in 
adding together the following : the present value of the first 
payment of $5 (namely that due one year hence) which is 
$5-^1.04, or $4.81, then that of the second which is 
$5-^(1.04)^ and so on up to and including the present 
value of the principal which is $100 -^ (1.04)^°. The sum 
is $108.17. 

Here the five per cent bond is said to be sold on a four 
per cent basis. Its capital- value ($108.17), at the begin- 
ning of the period represented {i.e., the value of a five per 
cent bond, valued on a four per cent basis), is obtained 
just as before, except that we now reckon by discounting 
at four per cent instead of at five per cent. Thus, in Fig- 
ure 7, we see that the value of the bond, just before it be- 
comes due, is $105, or AC; that its value one year earlier, 
just after the ninth interest payment, is A' B' , or $105 -f- 
1.04, or $100.96, and, just before the interest payment, is 
A'C' , or $100.96 -f $5, or $105.96 ; and so on back to its 
value at the beginning, MN, which is thus found to be 
$108.17.^ This is greater by $8.17 than the value of the 
bond as reckoned on the five per cent basis. The fact 
that four per cent has been used in our calculations instead 
of five per cent has made all of the discount curves less 
steep. 

We see, therefore, that nominally the rate of interest of 
the bond is not necessarily the actual rate of interest used in 
buying or selling that bond, and if the value of the bond is 
calculated on the basis of a rate of interest below the nominal 
rate of interest in the bond, the resulting value of the bond 

^ Of course, the same result could be obtained by discounting separately 
at four per cent each of the eleven items to which the bondholder is en- 
titled and adding the results together. The elements of which MN is 
composed may then be easily indicated just as, for the previous example, 
in Figure 6. 



Sec. 4] 



CAPITALIZING INCOME 



121 



will be above par. Nominally the rate of interest is that 
named in the bond and, as previously noted, this is the 
actual rate of interest if the bond is worth par, but not 
otherwise. The actual rate is always that rate by which 
the actual value of the bond is calculated from the pay- 
ments to which it entitles the holder. Tracing the history 
of the capital-value of the ten-year-five-per-cent bond 
reckoned at four per cent from the present toward the 
future, we may say that the rise in value during each 



M 









































5^ 


y 


c 


V^^j^oo 




























^ 


R 


y 


^^ 


y 


s 




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9" 


^ 


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^ 


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y 


y 


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y 




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B' 




B 


^92.61^ 


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80 






















































































70 






















































































€iO 






















































































SO 






















































































40 
























































































30 






















































































20 






















































































10 














































































ai 




Q 










S 




2. 




L 




5 




5 


L_ 


i 




L 




5 




5 




5 



34-5 

Fig. 8. 



6 



A' 



year is the interest accrued during the year on the capital- 
value at the beginning of the year. Thus, the rise in 
value during the first year is four per cent of $108.17, or 
$4.32, and in the last year is four per cent of $iQo.g6, or 
$4,038. It is also clear that the fall in the capital-value at 



122 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

the end of each year (except the last), when the pa3niient 
of the nominal interest is made, is exactly $5. That is, the 
income taken out each year is greater than the interest 
accruing during the year; hence the general decline in the 
capital-value of the bond. In the last year the income 
taken out is $105 ; although if the investor is v/ise, he will 
put back at least $100 into some other bond or equivalent 
property. 

The reverse is true if the present value of the bond is 
calculated on a six per cent basis, or on any other higher 
than the five per cent named in the bond. Figure 8 repre- 
sents the case of a five per cent bond valued on a six per 
cent basis. In this case the discount curves are steeper 
than in Figure 5, and the value of the bond at present, ten 
years before it becom.es due, is $92.61. In Figure 8, as in 
the preceding diagrams, we know that the rise of capital- 
value during any year is always the accruing interest on 
the capital-value at the beginning of that year. Thus, the 
rise in the first year will be six per cent of $92.61, that is, 
$5.55, and the rise during the last year will be six per cent 
of $99.05, namely, $5.95. It is also clear that the drop in 
capital-value at the end of each year is, as before, equal to 
the income taken out, or $5 ; that is, the income taken out 
each year is less than the interest accrued during the 
year ; hence the general increase in the capital- value of the 
bond. 

It will be seen (as shown in the three figures, 5,7, and 8) 
that the final value of the bond just before it becomes due 
will be $105 in all three cases, but that the present value is 
different in each case; namely, $100, $108.17, ^^^ $92.61. 
In each case the value zigzags year by year, but approaches 
in a general way $105 as its final value. If the " five per 
cent " bond is sold on an actual five per cent basis, the 
value of the bond is maintained year by year, as seen 
in Figure 5, where the curve indicating capital-value runs 
in general horizontally ; if it is sold on a four per cent basis, 



Sec. 4J 



CAPITALIZING INCOME 



123 



its value in general decreases, as shown by the descending 
trend of the curve in Figure 7 ; while, if it is sold on a six 
per cent basis, it tends to increase in value, as shown by 
the general upward trend in Figure 8. 

Elaborate tables have been constructed, called " bond- 
value books," calculated on the foregoing principles. They 
are used by brokers for indicating the true value of bonds on 
different bases ; that is, the prices a man ought to pay for 
bonds, at different rates of interest and having different 
times in which to mature, in order to realize on them the 
market rate of interest. These tables are also used for 
solving the converse problem, viz., for finding the true rate 
of interest " realized " when a bond is bought at a given price. 
This rate realized will be the market rate, if the man has 
paid the right price, but sometimes he pays a wrong price. 
Given the market rate, we can deduce the right price to 
pay. Given the actual price paid, we can deduce the 
actual rate realized. The following table is an abridg- 
ment of these brokers' tables, for a five per cent bond. 
The prices of such a bond are in all cases the prices imme- 
diately after an installment of interest has been received. 
In all cases the gradual increase in capital-value during 
any time is equal to the interest accruing during that time, 
while the sudden decrease at any time is equal to the value 

RATES OF INTEREST 
Five Per Cent Bond 







Years to Maturity 




Price 










I 


S 


10 


102 


3-0 


4.6 


4.8 


lOI 


4.0 


4.8 


4.9 


100 


5-0 


S-o 


5-0 


99 


6.1 


5-2 


S-i 


98 


7.1 


5.5 


5-3 



124 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

of the income taken out at that time. The only exceptions 
to these statements are when capital-value varies up or down 
because of changed opinion as to the chances of future in- 
come ; but we are here assuming that there are no uncer- 
tainties to be reckoned with. 

From this table we see that if the so-called five per cent 
bond is sold at $102, and has one year to run, it will 
"yield" the investor three per cent; that is, if three per 
cent is used in calculating its value, this value will be 
$102. Again, if the bond has five years to run and is sold 
at $102, it will yield the investor 4.6 per cent; and if ten 
years, 4.8 per cent. If the bond is sold at $98 and has 
one year to run, it will yield the investor 7.1 per cent; if 
ten years, 5.3 per cent. If it is sold at par, it will yield five 
per cent, whatever may be the number of years it has to run. 

The same principles as have just been applied to valuing 
bonds apply also to valuing any other article of property or 
wealth. The student will find it a useful exercise to draw 
diagrams for other cases. He may construct a series of 
diagrams, the vertical lines representing the successive items 
of income expected, and beginning at the last item proceed 
backward year by year, by a series of teeth, to obtain the 
present value of the capital. The value of the capital must 
always be first traced backward,hut, after it has been obtained, 
we may retrace our steps. 

The zigzag curves which have been indicated for bonds 
and which could be constructed for exhibiting the valua- 
tion of any other property right entitling the owner to 
definite sums of money or benefits of definite value at 
definite times are visual representations of the fact that 
the present value of any future benefit or collection of 
benefits gradually rises as the time grows near for their 
realization and suddenly falls as the realization occurs. 
The rate at which the value thus grows with time (between 
benefits-realized) is the rate of interest employed in these 
market valuations. 



Sec. s] 



CAPITALIZING INCOME 



125 



§ 5. Effect of Changing the Rate of Interest 

From what has been said, it is evident that the value of 
any article of capital depends very greatly on the rate of 
interest. If there were no rate of interest, or if, in other 
words, the rate of interest were zero, the value of the capital 
would be simply the sum of the values of the anticipated 
benefits. In the case of the five per cent bond, for instance, 
running for ten years, if reckoned on a zero per cent basis, its 
value would be simply the sum of the $100 and the ten in- 
terest payments, amounting to $50, or a total of $150. Since 
the rate of interest is always higher than zero, the value 
of the bond will always be lower than $150. To change I 
the rate of interest will always change the value of capital | 
in the opposite direction. For several generations the 
rate of interest has been falling, and consequently the 
value of bonds and of capital in general has tended to 
rise. Of course, the change in value of capital will be 
due also to many other circumstances than the change in 
the rate of interest, and, moreover, the effect of the 
change in rate of interest will not be the same on aU 
articles of capital. For instance, .the capital, the income 
from which is most remotely future, will be most affected. 
The following table shows ^ the effect of lowering the rate 



Capital 


Rate op 


Total 


Capital-Value 


Capital-Value 


Net Income per Year 


Income 


(Int. at s%) 


(Int. at 2\%) 


Land 


$1000 per yr. forever 


Infinite 


$20,000.00 


$40,000.00 


House 


$1000 per yr. for 50 










yrs. 


$50,000.00 


18,300.00 


28,400.00 


Horse 


$iooperyr. for6yrs. 


600.00 


508.00 


551-00 


Suit of 


$20 ist yr.; $10 2d 








clothes 


yr 


30.00 


28.00 


29.00 


Loaf of 


$36.50 per yr., for i 








bread 


day 


.10 


.10 


.10 



1 The figures in this table are worked out by the principle of discount- 
ing previously explained. 



126 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VI 

of interest from 5 per cent to 2^ per cent on five typical 
articles, whose incomes have different degrees of remote- 
ness. 

If the value of the benefits derivable from these various 
articles continues in each case uniform, but the rate of in- 
terest is suddenly cut down from 5 per cent to 25 per cent, 
there will result a general increase in the capital-values, but 
a very different increase for different articles. The more 
enduring ones will be affected the most. These effects are 
seen in the last two columns of the table. When the rate 
of interest is halved, the value of the land will be doubled, 
rising from $20,000 to $40,000, but the value of the house 
will rise by only about sixty per cent, namely, from $18,300 
to $28,400 ; the value of the horse will rise only ten per 
cent, namely, from $508 to $551 ; the value of the suit will 
rise only from $28 to $29 ; and, finally, the value of the 
loaf of bread will not rise at all, but will remain at 10 cents. 
We see from the changes in the values of these five types of 
articles that the sensitiveness of capital-value to a change 
in the rate of interest is the greater, the more remote the 
income, A high rate of interest requires a high premium 
on income near at hand as compared with income remotely 
future ; or, expressed the other way about, a high rate of 
interest diminishes the attractiveness of remotely future 
income as compared with income close at hand. 



CHAPTER VII 

VARIATIONS OF INCOME IN RELATION TO CAPITAL 

§ I. Interest Accrued and Income Taken Out 

We have seen how the value of capital is derived from that 
of income. We have also seen that the value of capital 
rises in anticipation of income and falls after its realization. 
The alternate rise and fall may or may not be equal. From 
the principles explained it is evident that the rise of the capi- 
tal-value as it ascends on the discount curve is equal to the 
interest accrued on that capital during that time, while the 
fall in that capital value due to the taking out of income 
is equal to the income taken out. If the income taken out 
is just equal to the interest, the capital is thereby restored 
to its original value. // more than this amount of income 
he taken out, the capital-value will he impaired, that is, made 
less than it was at the heginning of the period under considera- 
tion; if less, the capital-value will increase. 

When a man is said to own a capital fund of $1000, this 
means simply that he owns capital-goods worth that much ; 
and these capital goods are worth that much simply be- 
cause, in terms of money, the discounted value of the 
expected income from them is that much. The income 
which he expects may be a perpetual income flowing uni- 
formly or in recurring cycles ; or it may be an income like 
that from the bond, flowing recurrently for a limited time, 
at the end of which a large lump sum, ordinarily called the 
"principal," is returned in addition ; or it may be any one 
of innumerable other forms. Thus if we assume that five 

127 



128 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

per cent is the rate of interest used in calculating the capital- 
value, then any one of the following investments will have 
a present value of $1000 : a perpetual annuity of $50 per 
year ; or an annuity of $50 a year for ten years, together 
with $1000 at the end of that period ; or $100 a year for 
fourteen years, after which nothing at all; or $25 a year 
for ten years, followed by $167.50 a year for ten years, after 
which nothing at all; or any one of innumerable other 
forms. The student can easily prove that any one of these 
series of incomes, when discounted at five per cent, will 
make up a present value of $1000. 

In the first case the income taken out ($50 a year) is 
exactly equal to the annual accrued interest, for $50 is the 
interest for one year at five per cent on $1000. The same 
is true of the second instance mentioned, that of the five 
per cent bond, except in the last year when the income 
taken out ($1050) exceeds the interest for the year by 
$1000, thereby reducing the value of the bond to zero. 

In the third case the income taken out the first year 
is $100, while the interest accrued in that year is only $50. 
Thus the income taken out exceeds the accrued interest by 
$50. This excess of $50 involves a reduction of $50 in the 
capital- value of the property, which therefore becomes $950 
instead of $1000. Thus, at the end of the first year and 
after the $100 of income has been taken out, $950 is the 
discounted value of the remaining thirteen items of $100 a 
year for each year. In the second year the interest (on 
$950) is $47.50; whereas the income taken out is $100, the 
difference being $52.50. Hence, at the end of the second 
year, the capital-value of the remaining payments has been 
reduced by $52.50, becoming $897.50. Similarly, the capi- 
tal-value of the property decreases each year by the excess 
of the income over the accrued interest until the last in- 
come item of $100 is received ; after which, no more income 
being anticipated, the capital-value is zero. 

In the fourth case, the interest accruing during the first 



Sec. 2] VARIATIONS OF INCOME 1 29 

year is $50, whereas only $25 income is taken out at the 
end of the year, the difference being $25. Hence, at the 
beginning of the second year the capital- value of the bond 
goes up to $1025. During the second year, the interest (on 
$1025) is $51.25. After the receipt of the second income 
item of $25, therefore, the capital-value of the bond is in- 
creased by the difference ($26.25) and becomes $1051.25. 
Similarly, the value of the bond increases until after the 
payment of the tenth income item of $25, when it becomes 
$1314.43. The interest on this amount in the eleventh 
year is $65.72; whereas the income taken out that year, 
and each of the remaining nine years, is $167.50. Hence, 
from the beginning of the eleventh year to the end of the 
twentieth, the capital-value of the bond decreases, iinally 
reaching zero at the end of the period. 

The principle here shown may be summarized as follows : 
(i) When a property yields a specified foreknown income, 
and is valued by discounting that income at a specified rate 
of interest, if the income taken out is equal to the interest 
accrued, the value of the capital will be restored each year 
to the level of the year before. (2) If the income taken out 
exceeds the interest accrued, the value of the capital will fall 
below that of the year before, the amount of the fall being 
equal to the amount of the excess. (3) If the amount of in- 
come taken out is less than the interest accrued, the value of 
the capital will rise above that of the year before, the amount 
of the rise being equal to the amount of the deficiency. 

Briefly, the general principle connecting income taken out 
and interest accrued is that they differ by the net apprecia- 
tion or depreciation of capital. It is thus possible to describe 
interest accrued as income taken out less depreciation of cap- 
ital, or as income taken out plus appreciation of capital. 

§ 2. Illustrations 

In order that these important relations may be as clear, 
and vivid as possible, we shall illustrate them by concrete 



130 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 



examples, and by business accounting. The following table 
gives the income supposed to be taken out for five selected 
kinds of capital- wealth ; the capital- value found by dis- 
counting that income at five per cent ; the accrued interest 
for the first year ; the resulting change or net appreciation 
or depreciation of capital-value ; and the ratio of the first 
year's income to the original capital- value. 

The student will readily understand how the figures in 
the successive columns are calculated although the actual 
calculation of the third column (capital-value) from the 
second (income) is a tedious process involving in most 
cases the discounting of a large number of separate items. 



Capital- 


Income taken out 


Capital- 


Interest 

ACCRUED 


Increase 
( + ) OR De- 
crease ( — ) 


Ratio or 
First 
Year's 
Income to 
Original 
Capital- 


wealth 


PER Year 


(Int. at 5%) 


FOR First 
Year 


OF Capital- 
value IN 
First Ye.ar 














Forest land 


$1000 a yr. for 
14 yrs. and 
then $3000 a 








% 




yr. forever . 


$40,000.00 


$2000.00 


-l-$IOOO.OO 


2-5 


Farm land 


$1000 per yr. 












forever . 


20,000.00 


1000.00 


0.00 


5-0 


House 


$1000 per yr. 












for 50 yrs. . 


18,300.00 


915.00 


-85.00 


S-4 


Horse 


$100 per yr. for 












6 yrs. . . 


508.00 


25.40 


- 74.60 


19.6 


Suit of 


$20 istyr. ;$io 










clothes 


2d yr. . . 


28.00 


1.40 


-18.60 


71.4 



I. The forest land yields $1000 worth of income the first 
year on a capital-value of $40,000, from which, on the five 
per cent basis assumed, the interest accrued would be five 
per cent of $40,000, or $2000. Consequently, the income 
taken out ($1000) is less than the interest accrued ($2000) 
by $1000. Therefore the forest will appreciate in the year 
by the excess, $2000 — $1000, or $1000, and will be worth 
$41,000 at the end of the year. Similarly, it will continue 



Sec. 2] VARIATIONS OF INCOME 13I 

to appreciate for fourteen years, when it will be worth 
$60,000 ; after which the income that is annually taken out 
($3000) will be • equal to the annual accrued interest on 
$60,000. 

2. The farm land yielding $1000 a year in perpetuity 
is, on the five per cent basis, worth $20,000, and continues to 
be worth that amount each succeeding year. The income 
taken out ($1000) is always equal to the interest accrued 
from $20,000. 

3. The house yields an income of $1000 on a capital- 
value the first year of only $18,300. The interest accrued on 
$18,300 would be five per cent of $18,300, or only $915. The 
consequence is an excess of income taken out over interest 
accrued of $1000 — $915, or $85, and a corresponding fall 
of $85 in the value of the capital. That is, the house depreci- 
ates by $85 in the year, or from $18,300 to $18,215. It will 
continue to depreciate each year until its value vanishes 
entirely at the end of fifty years. 

4. The horse also depreciates, and very fast. Its owner 
Tealizes from the horse an income of $100 on a capital- value of 
$508, from which the interest accrued would be only $25.40. 
The difference between the income taken out and the interest 
accrued is $100 — $25.40, or $74.60, and the horse will lose 
that much in value during the year, and will continue to 
depreciate in value for all of the six years during which it 
yields income. 

5. The suit of clothes yields an income the first year of 
$20 on a capital of $28, from which the interest accrued 
would be only $1.40. It therefore depreciates by the differ- 
ence, $20 — $1.40, or $18.60. 

In all cases the interest accrued is 5 per cent of the capital- 
value, while the income taken out is in some cases a higher, 
and in some cases a lower, percentage. Expressed in per- 
centages, the actual rate of value-return {i.e., ratio of income 
taken out to capital) on the forest land is 2.5 per cent; 
on the farm land, 5 per cent; on the house, 5.4 per cent; 



132 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

on the horse, 19.6 per cent; and on the suit of clothes, 71.4 
per cent. The more rapidly the income is taken out, the 
greater the rate of value-return realized ; but (if that rate ex- 
ceeds the rate of interest) the more rapidly will the capital 
be exhausted. The house yields a rate but slightly higher 
than the rate of interest, and lasts 50 years ; the horse yields 
a rate nearly 4 times the rate of interest, but it lasts only 6 
years ; and the clothes yield a rate over 14 times the rate of 
interest, but last only 2 years. The farm land, which yields 
a rate exactly equal to the rate of interest, lasts forever, 
while the forest land, which yields a rate only half the rate 
of interest, not only lasts forever, but also increases in 
value for the first 14 years. 

The various cases supposed may also be illustrated by the 
dividends declared by a joint stock company. If a company 
declares dividends of five per cent, when it earns five per 
cent, these dividends will be the interest accrued on the 
capital and will leave it intact. If the dividends are less than 
five per cent, capital will be accumulated; that is, a "sur- 
plus" will be added to the original capital. If the dividends 
are greater than five per cent, the capital or surplus pre- 
viously accumulated will be decreased. In the last-named 
case the company is said to pay its dividends partly "out of 
capital." Such a practice is unusual, and when it occurs is 
generally condemned because of an assumed intention to de- 
ceive as to the abihty to pay dividends. 

A case at the opposite extreme occurs when the dividends 
are made unusually small in order that the capital may be 
increased. There is in New York City a company which has 
never declared any dividends, but has been roUing up a large 
surplus for years, and whose stock is for this reason much 
above par. 

§ 3. Confusions to be Avoided 

With all the preceding explanations and illustrations the 
distinction between income taken out and interest accrued 



Sec. 3] VARIATIONS OF INCOME 133 

should be clear. Interest accrued is the income which, 
if it were taken out, would maintain capital intact, neither 
impaired nor increased, at the value it had at the beginning 
of the period under consideration. 

Of the two concepts, income taken out and interest ac- 
crued, the former is by far the more fundamental. Every- 
thing else depends upon income expected to be taken out. 
We cannot, as would at first seem possible, begin with capital- 
value and derive the actual income from it; nor can we 
begin with interest accrued, for interest accrued presupposes 
some capital- value. That is, interest accrued depends on 
capital- value, and capital-value depends on income to he taken 
out. The order of dependence, then, is income taken out, 
capital-value, interest accrued. It is not uncommon to con- 
fuse these three concepts. The illustrative table (§ 2) of 
this chapter will help to keep us from confusing them. For 
instance, from this table we see clearly one reason why 
certain articles have been erroneously identified with income. 
Clothes have nearly the same capital- value as income-value, 
so that, if a person were not accustomed to fine distinctions, 
he might think it unnecessary to discriminate between the 
$30, which is the total value of the use of the clothes for two 
years, which is, therefore, income, and the $28, which is the 
value of the clothes themselves, and which is, therefore, capi- 
tal. There is almost as much danger of such confusion in 
the case of the horse ; for there is no very great difference 
between the $600, the value of the use of the horse, and the 
$508, which is the value of the horse. As we pass to the 
more enduring articles, there emerges so wide a difference 
between the value of the use of an article and the value of 
the article itself, that there is no difficulty in distinguishing 
between them. But if the distinction is valid in one case, and 
all acknowledge that it is, it is valid in the others. We find no 
difficulty in distinguishing between the shelter of a house, 
which is income, and the house itself, which is capital ; nor 
between their values. Thus the shelter is worth $1000 a 



134 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. VII 

year for 50 years (or $50,000 in all), whereas the house itself 
is the discounted value of all this $50,000, or only $18,300. 
We ought to find no greater difficulty in distinguishing be- 
tween the horse and the use of the horse, nor between the 
clothes and the use of the clothes. 

The more rapidly any capital yields up its benefits, that 
is, the greater the rate at which its income is taken out, the 
more the danger of confusing the capital with the income it 
yields. 

We have shown the tendency to confuse three concepts — 
interest accrued, income taken out, and capital-value. We 
have also dealt with a fourth concept, which must not be 
confused with the other three, viz., appreciation or deprecia- 
tion. Appreciation is also sometimes called savings, for 
savings in its broadest sense includes more than simply saved 
money. It includes all the net increase in capital- value after 
all income has been detached. It is the net appreciation, 
or the difference between the interest accrued and the income 
taken out. Savings are therefore still a part of capital. 
They are the part of capital saved from being taken out 
for income. They are not a part of income taken out. 
The individual is always struggHng between saving more 
capital and taking out more income. He cannot do both — 
have his cake and eat it too. A savings bank depositor is 
sometimes thought to draw income from his deposit when 
the interest merely " accumulates " in the bank. This is 
an error. The bank renders income to the depositor when, 
and only when, money is drawn out of it. It occasions 
him outgo when, and only when, money is put into it. If 
the depositor merely lets his deposit accumulate, he derives 
no income and suffers no outgo. There is no effect on in- 
come. The only effect is upon capital, which is made to 
increase. If we accept the fiction that the man who allows 
his savings to accumulate virtually receives the interest, we 
must, to be consistent, also accept the fiction that he re- 
deposits it and so cancels the receipt. If the teller hands 



Sec. 3] VARIATIONS OF INCOME 135 

over the interest across the counter, the depositor's account 
or claim against the bank certainly yields up '• income " to 
him, but if the depositor hands it back, the account occasions 
" outgo," and the net result is simply a cancellation. To 
allow a deposit to accumulate is evidently equivalent to this 
double operation. We see, then, that net appreciation is not 
income, but is an addition to capital. Likewise, net de- 
preciation is not outgo, but is a subtraction from capital. 
Almost every article except land ultimately depreciates in 
value, owing to the fact that the services which it still re- 
mains capable of rendering gradually diminish in number 
and value. The approaching cessation of services may be 
due to physical wear and tear, but not always. Sometimes 
the expression " wear and tear " is a misnomer. There are 
articles which suffer no physical change, but of which the 
services, nevertheless, last only a limited period. On the 
Atlantic coast the fishermen sometimes construct temporary 
platforms which are pretty sure to disappear in the Septem- 
ber gales. It is evident that without any physical deteriora- 
tion during the summer the value of such property must, 
nevertheless, decrease rapidly as the end of the fishing sea- 
son approaches. The " World's Fair " buildings at St. 
Louis depreciated, during the brief period of the fair, from 
$15,000,000, which was first paid for their construction, to 
$386,000, for which they were sold after they had served 
their main purpose during the few months of the Fair. The 
buildings equipping a mine become worthless when the mine 
is exhausted. " Wear and tear," therefore, is a phrase 
which we should use only in a metaphorical sense. Even 
when there is actual physical deterioration, this deterioration 
affects the value only in so far as it decreases or terminates 
the flow of income, and not directly because of a physical 
change in the capital which bears the income. 

There are, then, four concepts which we must keep dis- 
tinct. Stated in the order of dependence on income taken 
out, these concepts are : — 



136 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

(i) Income (value) taken out. 

(2) Capital-value (the discounted value of expected in- 
come to be taken out) . 

(3) Interest accrued (the interest on capital-value). 

(4) Appreciation (the excess of interest accrued over 
income taken out) , and its opposite, depreciation (the excess 
of income taken out over interest accrued). 

This order of dependence together with the dependence 
of the first element (income taken out) on antecedent ele- 
ments previously explained may be conveniently expressed 
in a scheme as follows : — 

Capital wealth— >• Benefits (income) 

<-..,, , -^r" Income (value) taken out! f Appreciation or 
(_-apitai value t ^ ^ 1 1 ^ 1 i . . • 

"^^ Interest accrued J [ depreciation 

§ 4. Standardizing Income 

Various devices have been used to make income taken out 
agree with interest accrued. The method of the depre- 
ciation fund has already been mentioned under income 
accounts, and before the relation of income to capital was 
explained. By means of a depreciation fund, an irregular net 
income is converted into a regular net income ; and we know 
that the capital- value of a perpetually regular income will 
remain constant. For instance, the possessor of $18,300 
purchases a house and obtains at first an income worth 
$1000 a year. He knows, however, that by the end of 
50 years the house will need to be rebuilt, and therefore 
sets aside a depreciation fund into which he pays annually 
a sum equal to the depreciation of his house. This, in the 
first year, is $85, as we have seen. The depreciation fund 
costs him this sum as outgo the first year. At the end of 
50 years his depreciation fund, accumulated at interest, 
is large enough to rebuild the house. Although the house 
by itself does not yield him a uniform income of $915 for- 



Sec. 4] VARIATIONS OF INCOME I37 

ever, but instead $1000 a year for 50 years, yet the house 
and the depreciation fund taken together yield him the $915 
in perpetuity, oj as long as he keeps up the system. 

In this way, any article of capital may be made to yield a 
uniform perpetual income, not by itself, but conjointly with 
a depreciation fund. The latter is often forgotten. Only 
by actually paying into this fund can income taken out be 
made to agree with interest accrued. Merely to reckon what 
the depreciation is will not make the income taken out agree 
with the interest accrued. Reckoning depreciation is as 
poor a substitute for providing a fund to meet depreciation 
as Beau Brummel's keeping a dinner hour was a substitute 
for a dinner. Of course, depreciation payments only rectify 
or change the distribution in time of one man's income at the 
expense of some other man's income. That is, every addi- 
tion and subtraction caused in the one man's income implies 
equal and opposite changes in some other man's. A banker 
must be found who is willing to take the $85 and succeeding 
payments into the depreciation fund and to pay back 
$18,300 at the end of 50 years. 

Another and simpler method of keeping income steady 
is to take care that one's capital shall consist of a large 
number of instruments at different stages of production or 
consumption. If a weaving mill is equipped with twenty 
looms of the same degree of wear, the value of this plant 
will evidently diminish, and a depreciation fund may be 
necessary. But if the twenty looms are evenly distributed 
throughout the different stages of wear, and if we assume 
that one loom wears out each year and is replaced at a 
regular cost, no depreciation fund will be necessary. The 
replacement of one loom annually is equivalent to such a 
depreciation fund, and the capital is thereby maintained at a 
uniform level. This method, which consists in properly 
assorting and combining a large number of instruments, 
is the chief reliance for steadying the income of society as 
a whole, for to society as a whole purely shifting devices, 



138 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

such as borrowing, are inapplicable, since society can find 
no outside party on whom to shift the fluctuations. 

In a new country just being opened up, such as the 
early American colonies, little income can at first be ob- 
tained because almost all the stock of wealth, especially 
the land, is, with respect to ability to 5deld income, in an 
embryonic stage, so to speak. The first settlers must, there- 
fore, wait several years before they can get a comfortable 
living. An older country, on the other hand, such as the 
United States to-day, will have its capital better assorted. 
Only part of its capital will be in the embryonic stage — 
young forests, new mines, railways in process of construc- 
tion. Other capital will be in full operation, 5delding a large 
stream of benefits — older forests, mines, railways, factories, 
farms, dwellings, etc. 

§ 5. The Risk Element 

There is one important feature in the relation between 
capital-value and income-value which has not yet been 
mentioned. This is the fact that at any point of time when 
we take account of capital-value, the future income from 
which it is obtained is only imperfectly foreknown. The 
capital-value is the discounted value of the future expected 
income, with all the chances of loss or gain included in pres- 
ent expectations. 

Hitherto we have assumed that the entire future history 
of the capital in question is definitely known in advance; 
in other words, we have ignored chance. The articles of 
capital which were taken for illustration were supposed to 
yield definite future income which could be counted upon, pre- 
cisely as the interest payments on a bond may be counted on 
by the bondholder. But as every enterprise offers chances 
of both gain and loss, we cannot close our discussion of the 
relation of income to capital without some account of how 
these chances affect the matter. 



Sec. 5] VARIATIONS OF INCOME 139 

It has been explained that capital-value increases with 
the approach of an anticipated installment of income, and 
diminishes when, that installment is taken out or received. 
These changes in capital- value take place when the future in- 
come is regarded as certain. The introduction of the ele- 
ment of chance will bring other and even more important 
changes in capital- value. If we take the history of the prices 
of stocks and bonds, we shall find it to consist chiefly of a 
record of changing estimates due to what is called chance, 
rather than of a record of the foreknown approach and de- 
tachment of income. Few, if any, future events are entirely 
free from uncertainty. In fact, property, by its very defi- 
nition, is simply the right to more or less probable future 
benefits. The owner of a mine takes his chances as to what 
the mine will yield ; the owner of an orange plantation in 
Florida takes his risk of winter frosts ; the owner of a farm 
assumes risks as to the effect of sun and rain and other 
meteorological conditions, as well as the risks of the ravages 
of fire, insects, and pests generally. In buying an overcoat 
a man takes some risk as to its effectiveness in excluding 
cold, and as to the length of time it will continue to be ser- 
viceable. Even what are called " gilt-edged " securities are 
not entirely free from risk. Strictly speaking, therefore, 
every owner of property is a risk bearer. 

We may now take a bird's-eye view of the capital and 
income of any country, such as the United States. We 
have seen that the capital of the United States consists of 
over a hundred bilHon dollars' worth of articles of various 
kinds, mostly real estate, and that the income consists of 
several billion dollars' worth of nourishment, clothing, shel- 
ter, and other satisfactions. We now see how the capital 
is related to the income. All income comes from capital 
(in its broader sense) whether, as is frequently the case, 
the capital is a human being, or some other form of wealth. 
The income produced by capital gives value to that capital ; 
for instance, the fruit borne by a tree gives value to the tree. 



I40 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

Business men seldom assign value to human beings by 
capitalizing their earning power, although statisticians oc- 
casionally do this. But other forms of capital are com- 
monly valued by capitalizing the income which they yield, 
that is, the one hundred and odd billions of dollars which 
our national capital is worth represent merely the discounted 
value of the nation's net future satisfaction which, it is 
expected, that capital will ultimately produce. The value 
of our capital is merely the present value of the future 
" living " of ourselves and our descendants. Most of the 
capital does not directly produce that "living" — does 
not turn out bread and butter ready-made ; but contributes 
to it only indirectly — • by growing the wheat which will be 
made into bread or pasturing the cows from whose milk the 
butter will be churned. But all of the capital has as the 
goal toward which its services aim the production of bread 
and butter and the other necessities, comforts, and amuse- 
ments of life the enjoyment of which constitutes our " Hv- 
ing " or real income ; and each individual article of this 
capital derives its value from the value of the services it 
is expected to render in helping toward this goal. These 
expectations may never be realized, and often are not real- 
ized, or the expectations may be surpassed by realization. 
But in either case it is expectation and not realization which 
gives the value to capital ; and any change in expectations, 
whether occasioned by a shock to business confidence, a 
rumor of war, or any other cause, will tend to change the 
value of our national capital. 

§ 6. Review 

The preceding chapters are intended to give a definite 
picture of the mass of capital and its benefits to man. In 
such a picture we see man standing in the midst of a 
physical universe ; the events of this universe affect his life 
favorably or unfavorably. Over many of these events he 



Sec. 6] VARIATIONS OF INCOME 14I 

can exercise no control or selection; they constitute his 
natural environment. Over others he exercises selection 
and control by assuming dominion over part of the physical 
universe and fashioning it to suit his own needs. The parts 
of the material world which he thus appropriates consti- 
tute wealth, whether they remain in their natural state or 
are "worked up" by him into products to render them more 
suitable to his needs. This mass of instruments will con- 
sist, first, of the appropriated parts of the surface of the 
earth, the buildings and structures attached to the soil, and 
the movable objects or "commodities" which man possesses 
and stores up; and, secondly (if we take wealth in its 
broader sense), of human beings. 

This mass of instruments serves man's purpose in so far 
as its possession enables him to modify the stream of occur- 
rences. By means of land and the modifications to which 
he subjects it he is enabled to increase and improve the 
growth of the vegetable and animal kingdoms in such a way 
as to supply him with food and the materials for constructing 
other instruments. By means of dwellings and other build- 
ings he is enabled to avert or minimize the unfavorable 
effects of the elements upon his body and upon the articles 
of wealth which he stores in those buildings. By means of 
machinery, tools, and other instruments of production, he 
is enabled to fashion new instruments, to add to his store of 
goods or to supply the place of those destroyed or worn out. 
By means of the final finished products which minister to his 
more immediate enjoyments — such, for instance, as food, 
clothing, books, ornaments — he is enabled to consummate 
the purposes for which the entire mass of wealth is produced 
and kept in existence; namely, the satisfaction of his 
desires, whether these be for the necessities, the comforts, 
the luxuries, or the amusements of life. In these and 
other ways the stock of wealth will modify the course of 
natural events in a manner more or less agreeable to the 
owner. These desirable changes in the stream of events 



142 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VII 

which occur by means of wealth constitute the benefits 
of wealth. 

But these benefits are obtained by dint of certain costs. 
In the last analysis, costs are simply human efforts, and 
benefits are simply human satisfactions ; but the interval be- 
tween efforts and satisfactions is divided into so many stages, 
and at each of these stages there are so many processes of 
production or exchange, that these intermediate occurrences, 
or interactions, are much more in evidence than either the 
efforts which precede them or the satisfactions which follow. 
Each interaction is accounted as a benefit with respect to 
the producing article or agent, and a cost with respect to 
that on account of which it occurs. 

The whole economic structure therefore — all that is 
represented in capital and income accounts — rests on two 
ultimate elements, namely, efforts and satisfactions. These 
enter our accounts, transformed simply by means of factors 
called prices, including that important price called the rate 
of interest. By means of such price factors, we reach 
from these elements, first, the interactions which depend 
on them, then the complete income and outgo accounts 
(containing the values not only of interactions, but of ef- 
forts and satisfactions as well), and then the capital ac- 
counts (containing the discounted values of the items in the 
income accounts). 

To recapitulate in a few words the nature of capital and 
income, we may now say that those parts of the material uni- 
verse which at any time are under the dominion of man, 
constitute his capital- wealth ; its ownership, his capital- 
property; its value, his capital- value. Capital- value im- 
plies anticipated income, which consists of a stream of bene- 
fits or its value. When values are considered, the causal 
relation is not from capital to income, but from income to 
capital ; not from present to future, but from future to pres- 
ent. In other words, the value of capital is the discounted 
value of the expected income. The fluctuations of this 



Sec. 6] VARIATIONS OF INCOME 1 43 

capital-value will, barring chance, be equal and opposite to 
the divergencies of " income taken out " from "interest ac- 
crued." When the influence of chance is included, there 
will be in addition to these fluctuations still others which 
mirror the successive changes in the outlook for future 
income. 



CHAPTER VIII 

PRINCIPLES GOVERNING THE PURCHASING POWER OF MONEY 

§ I. Introductory 

We have now finished the first great division of our sub- 
ject — a study of the foundation stones of Economics and 
how they fit together. These foundation stones are wealth, 
property, benefits, costs, capital, and income. Our study 
has so far consisted in pointing out the nature and rela- 
tions between these various concepts, and particularly be- 
tween capital and income. 

All of these relations find expression by means of prices. 
By prices, as we have seen, a miscellaneous collection of 
goods may be translated into a homogeneous mass of money- 
values. Only by such reduction to a common money basis 
are capital and income accounts possible. Capital accounts 
and income accounts are groups of heterogeneous elements re- 
duced to common terms by means of prices. But in all the 
capital and income accounts to which reference has thus far 
been made, and in all our previous discussions, we have 
taken prices for granted. We have, in other words, started 
out in our investigations upon the assumption that prices 
were fixed and known. But inasmuch as prices themselves 
are the outcome of economic forces, they must in turn be 
made the subject of analysis, and we must consequently 
now take up the second part of our task, which consists in 
discovering the principles that determine prices. 

If one were to ask how the price of wheat is determined, 

144 



Sec. i] purchasing POWER OF MONEY I45 

the immediate answer would probably be : By supply and 
demand. This answer, though correct so far as it goes, is 
superficial. It is well to be on one's guard against glib 
phrases which are so often substituted for real analyses. 
" Supply and demand " is such a phrase. A long time ago, 
when economics consisted rather of glib phrases than of real 
analyses, a critic of the study said, " If you want to make 
a first-class economist, catch a parrot and teach him to say 
* supply and demand ' in response to every question you 
ask him. What determines wages? Supply and demand. 
What determines the distribution of wealth? Supply and 
demand." In every instance the answer is right, but it 
explains nothing. We must discover the forces which 
determine supply and demand. In so doing we shall learn 
that to determine the price even of one simple commodity, 
like wheat, involves practically all the principles of economic 
science. 

We are now ready to undertake — not the full study of 
the supply and demand of any article — but one of the im- 
portant forces underlying the supply and demand of all 
articles. That force is the purchasing power of money, a 
force as subtle as it is omnipresent. As every price is ex- 
pressed in money, it is evident that the willingness to take 
or give a certain amount of any article at a given price in 
money depends on the willingness to give or take a certain 
amount of money in exchange. This willingness to give or 
take money depends on the purchasing power of money over 
other things. Will a man pay ten cents for a pound of sugar ? 
That depends on whether or not he wants the sugar more 
than something else purchasable with the ten cents. The 
man, in other words, balances in his mind the sugar and the 
money — the latter standing in his mind for any goods he 
could spend it for. If the purchasing power of money is 
high, he will conceive so high a regard for money as to be 
reluctant to part with a given amount of it for a given quan- 
tity of sugar, i.e., he will be willing to pay only a low price 

L 



146 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

for sugar. The seller, on the other hand, is more eager to 
take a unit of money when it has a high purchasing power, 
i.e., he is more willing to take a low price for sugar. Hence, 
if in a given year money has a high purchasing power, the 
price of sugar will be low. We see then that the price of 
any particular article will tend to be low if money has a high 
purchasing power ; that is, if the prices of articles in general 
are low. It is therefore clear that the money price of every 
particular commodity depends partly on the prices of other 
commodities, i.e., on the general level of prices ; just as the 
actual height reached by a particular wave of the sea depends 
partly on the general level of the tides, or as the actual 
height of a spire depends on the elevation of the ground 
on which it stands. 

The phrases " the purchasing power of money " and " the 
general level of prices " are reciprocal. To say that the pur- 
chasing power of money is high or low is the same thing as to 
say that the general level of prices is low or high, respec- 
tively. If the price level is doubled, the purchasing power 
of money will be halved, and vice versa. 

It is possible to study the general level of prices inde- 
pendently of particular prices, just as it is possible to study 
the general tides of the ocean independently of its particular 
waves. Moreover, it is not only more logical to study the 
general price level first, but this order of study has also the 
advantage of acquainting us as early as possible with the 
nature of money. Therefore, before we attempt to explain 
even the price of wheat in particular, we shall first take up 
the study of prices in general. 

In practice, money is a most convenient device, but in 
theory it is always a stumbling-block to the student of 
economics, who is exceedingly prone to misunderstand its 
functions. At the beginning of this book we pointed out 
some of the imagined functions of money that do not 
belong to it. We are now in a position to ask : What are 
the rea/ functions of money ? 

/ 



Sec. 2] PURCHASING POWER OF MONEY 1 47 

§ 2. The Nature of Money 

We define money as goods generally acceptaUe in exchange 
for other goods. The facility with which it may thus be ex- 
changed, or its general acceptability, is the chief character- 
istic of money. The general acceptabiHty may be reenforced 
by law, the money thus becoming "legal tender" {i.e., money 
which may be legally tendered or^offered by a debtor to his 
creditor as a means of discharging his obligations expressed 
in terms of money units and which the creditor must 
accept). But such reenforcement is not essential. All 
that is necessary in order that any good may be money 
is that general acceptability shall attach to it. On the 
frontier, without any legal sanction, money is sometimes 
gold dust or gold nuggets. In the colony of Virginia it 
was tobacco. Among the Indians in New England it was 
wampum. 

How does it happen that any particular commodity 
comes into use as money? Not originally because a 
government so decreed, but because the commodity was 
very salable for other uses than money and could be readily 
resold. Thus gold was readily sold and resold. Many 
wanted it for jewelry, and many others could easily be 
induced to accept it in exchange, even if they had no 
personal use for it themselves, for they knew they could 
resell it at any time to some one who had such a use for 
it. Gradually it became customary to accept it with no 
thought of any other use than to resell it or pass it 
on indefinitely. Gold has finally survived as the most im- 
portant form of money. It is easily transportable and is 
durable. 

There are various degrees of exchangeability which must 
be transcended before we arrive at real money. Of all kinds 
of goods, one of the least exchangeable is real estate. It is 
often difficult to find a person who wants to buy a particular 
piece of real estate. A mortgage on real estate is one degree 



148 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

more exchangeable. Yet even a mortgage is less exchange- 
able than a well-known and safe corporation security, or 
a government bond. One degree more exchangeable than 
a government bond is a time bill of exchange ; one degree 
more exchangeable than a time bill of exchange is a sight 
draft; while a check is almost as exchangeable as money 
itself. Yet no one of these is really money, for none of 
them is " generally acceptable." 

If we confine our attention to present and normal condi- 
tions, and to those means of exchange which either are 
money or most nearly approximate it, we shall find that 
money itself belongs to a general class of goods which we may 
call " currency " or '' circulating media." Currency may 
be any kind of goods which, whether generally acceptable 
or not, do actually, for their chief purpose and use, serve as 
a means of exchange. 

Currency consists of two chief classes : (i) money ; (2) 
bank deposits, which will be treated fully in the next chap- 
ter. By means of checks, bank deposits serve as a means of 
payment in exchange for other goods. A check is the evi- 
dence of the transfer of/bank deposits. It is acceptable to 
the payee only by his consent. It would not be generally 
accepted by strangers. Yet by checks, bank deposits, even 
more than money, do actually serve as a medium of ex- 
change. In this country bank deposits subject to check, or, 
as they are sometimes called, "deposit currency," are by far 
the most important kind of currency or circulating media. 

But although a bank deposit transferable by check is 
included in circulating media, it is not money. A banlc note, 
on the other hand, is both circulating medium and money. 
Between these two lies the final line of distinction separat- 
ing what is money and what is not. The line is delicately 
drawn, especially in the case of such checks as cashier's 
checks or certified checks. For the latter are extremely 
similar, in respect to acceptability, to bank notes. Each is 
a demand liability on a bank, and each confers on the holder 



Sec. 2] PURCHASING POWER OF MONEY 149 

the right to draw money. Yet while a bank note is generally 
acceptable in exchange, a check is acceptable only by special 
consent of the payee. Real money is what a payee accepts 
without question, because he is induced to do so by " legal 
tender " laws or by a well-established custom. 
. Of real money there are two kinds: primary and fidu- 
ciary. Money is called primary if it is a commodity any 
given unit of which has just as much value in some use 
other than money as it has in monetary use; that is, 
primary money is a commodity which has its full value 
even if it is not used as niioney or even if it is changed to 
a form in which it will not circulate as money. For in- 
stance, gold coins in the United States are primary money, 
since their value will be undiminished even if they are 
melted into gold bullion. In the same way, the tobacco 
money of Virginia in old days was primary, having as much 
value as tobacco as it had as money. Fiduciary money, 
on the other hand, is money the value of which depends 
partly or wholly on the owner's confidence that he can ex- 
change it for primary money, or at any rate for other goods, 
e.g., for primary money at a bank or government office or for 
discharge of debts or purchase of goods of merchants. For 
instance, a silver dollar in the United States is fiduciary 
money, since it is worth a dollar only because of the public 
confidence that the government will take it in taxes and the 
people in discharge of debts and for other purposes on equal 
terms with a dollar of gold. If a silver dollar be melted 
into bullion, it will, unlike the gold dollar, lose a large part 
of its value. That is, the bulHon in a silver dollar is not 
worth a dollar ; it is only worth about forty cents. Our 
other silver coins are worth as bullion even less in propor- 
tion to their value as money, and our nickel and bronze coins 
are worth still less in proportion. Bank notes, government 
notes, and other forms of paper money are still more striking 
examples of fiduciary money, being practically worthless as 
paper, but having a high value as money, owing to the con- 



150 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 



fidence that they can be exchanged for gold at the banks or 
the government treasury. The larger part of the money in 
use in the United States is fiduciary money, the chief ex- 
amples being silver dollars, fractional silver, minor coins, 
silver certificates, gold certificates, government notes (nick- 
named "greenbacks"), and bank notes. The exact nature 
of these various kinds of money constitutes a subject outside 
the purpose of this book. The student can, however, learn 
much as to their nature for himself, by reading the inscrip- 
tions on the various forms of money, which, from time to 
time, pass through his hands.-^ 

The quahties of primary money which make for exchange- 
ability are numerous. The most important are portability, 

durability, and divisibil- 



BANK 
DEPOSITS. 


ity. The chief quality of 
fiduciary money, which 
makes it exchangeable, is 
its redeemabihty in pri- 
mary money, or else its 
imposed character of 
" legal tender." 


FIDUCIARY 
MONEY 


SEVEN 
BILLIONS. 


Figure 9 indicates the 
classification of all circu- 


PRIMARY 

MONEY. 

ONE-W^LF 

BtLLlON. 


ONE 
BILLION 


iating media in the 
United States. It shows 
that the total amount of 






Fig. g. 


circulating media is about 
eight and one half bil- 



lions, of which about seven biUions are bank deposits sub- 
ject to check, and one and one half bilhons, money; and 
that of this one and one half biUions of money one billion is 

1 Some economists have proposed that what is here called " fiduciary " 
money should not be called money at all ; that is, that the term " money " 
should be restricted to primary money. It seems preferable, however, here 
as elsewhere, to follow ordinary usage. There are instances where countries 
have for a time had no primary money, but only fiduciary money. 



Sec. 3] PURCHASING POWER OF MONEY 151 

fiduciary money and only about half a billion primary 
money. 

In the present chapter we shall exclude the consideration 
of bank deposit or check circulation and confine our atten- 
tion to the circulation of money, primary and fiduciary. In 
the United States, the only primary money is gold coin. 
The fiduciary money includes token coins and paper money. 

Checks aside, we may classify exchanges into three groups : 
the exchange of goods against goods, or barter ; the exchange 
of money against money, or ^'changing" money; and the 
exchange of money against goods, or purchase and sale. 
Only the last-named species of exchange involves what we 
call the circulation of money. The circulation of money 
signifies, therefore, the aggregate amount of its transfers 
against goods. All money held for circulation, i.e., for 
use in payment for goods purchased is called money in 
circulation. This includes the money in the pockets and 
purses of the people or the tills and safes of merchants. In 
the United States this includes all money except what is in 
the vaults of the banks and of the United States government. 

§ 3. The Equation of Exchange Arithmetically Expressed 

Having learned something of the nature of money, we 
are ready to study the causes which determine the pur- 
chasing power of money ; in other words, the causes which 
determine the general level of prices. 

If we overlook for the present the influence of checks, we 
may say that the price level depends on only three sets of 
causes : (i) the quantity of money in circulation ; (2) its 
" efiiciency " or velocity of circulation (or the average num- 
ber of times a year a dollar is exchanged for goods) ; and (3) 
the volume of trade (or amount of goods per year bought by 
money). The so-called " quantity theory " {i.e., the theory 
that prices vary proportionally to money) has often been 
incorrectly formulated, but it is correct in the sense that 



152 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

the level of prices varies directly with the quantity of 
money in circulation, provided the velocity of circulation of 
that money and the volume of trade effected by means of it 
are not changed. This theory will be made clearer by the 
equation of exchange, which is now to be explained. 

The equation of exchange is a statement, in mathematical 
form, of the total transactions effected in a certain period 
in a given community. It is obtained simply by adding 
together the equations of exchange for all individual trans- 
actions. Suppose, for instance, that a person buys 10 
pounds of sugar at 7 cents per pound. This is an exchange 
transaction, in which 10 pounds of sugar have been regarded 
as equivalent to 70 cents, and this fact may be expressed 
thus : 70 cents =10 pounds of sugar multiplied by 7 cents 
a pound. Every other sale and purchase may be expressed 
similarly, and by adding them all together we get the equa- 
tion of exchange for a certain period in a given community ; 
that is, the left side represents all the money spent and 
the right represents the value of all goods bought within 
the given period. During this period, however, the same 
money may serve, and usually does serve, for several trans- 
actions. For that reason the left or money side of the 
equation is, of course, greater than the total amount of 
money in circulation. / 

The equation has a goods side and a money side. The 
money side is the total money exchanged, and may be con- 
sidered as the product of the quantity of money multiplied 
by the rapidity of its circulation, i.e., the number of times it 
is exchanged for goods. This important magnitude, called 
the velocity of circulation or rapidity of turnover, means 
simply the quotient obtained by dividing the total money 
payments for goods in the course of a year by the average 
amount in circulation by which these payments are effected. 
This velocity of circulation in an entire community is a sort 
of average of the rates of turnover of different persons. 
Each person has his own rate of turnover which he can 



Sec. 3] PURCHASING POWER OF MONEY 1 53 

readily calculate by dividing the amount of money he ex- 
pends per year by the average amount he carries. The 
goods side of the equation is made up of the quantities of 
goods multiplied by their respective prices. 

Let us begin with the money side. If the number of 
dollars in a country is 5,000,000, and the velocity of circu- 
lation of these dollars is twenty times per year, then the 
total amount of money expended (for goods) during any 
year is $5,000,000 times twenty, or $100,000,000. This is 
the money side of the equation of exchange. 

Since the money side of the equation is $100,000,000, the 
goods side must be the same. For if $100,000,000 has been 
spent for goods in the course of the year, then $100,000,000 
worth of goods must have been sold in that year. In order 
to avoid the necessity of writing out the quantities and 
prices of the innumerable varieties of goods which are actu- 
ally exchanged, let us assume for the present that there are 
only three kinds of goods — bread, coal, and cloth ; and 
that the sales are : — 

200,000,000 loaves of bread at $ .10 a loaf, 
10,000,000 tons of coal at 5.00 a ton, and 
30,000,000 yards of cloth at i.oo a yard. 

The value of these transactions is evidently $100,000,000, — 
i.e., $20,000,000 worth of bread plus $50,000,000 worth of 
coal plus $30,000,000 worth of cloth. The equation of ex- 
change, therefore, is as follows : — 

$5,000,000X20= 200,000,000 loaves X $ .10 a loaf 
+ 10,000,000 tons X 5.00 a ton 
-1-30,000,000 yards X i.ooayard. 

This equation contains on the money side two magnitudes, 
viz., (i) the quantity of money, and (2) the number of 
times it circulates or is '' turned over "ma year ; and 
on the goods side two groups of magnitudes in two columns, 



154 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

viz., (i) the quantities of goods exchanged in a year 
(loaves, tons, yards), and (2) the prices of these goods ($.10 
per loaf, $5.00 per ton, and $1.00 per yard). The equation 
shows that these four sets of magnitudes are mutually re- 
lated. Because this equation must be fulfilled, the prices 
must bear a relation to the three other sets of magnitudes — 
quantity of money, rapidity of circulation, and quantities 
of goods exchanged. Consequently, these prices must, as a 
whole, vary proportionally with the quantity of money and 
with its velocity of circulation, and inversely with the quan- 
tities of goods exchanged. 

Suppose, for instance, that the quantity of money were 
doubled, while its velocity of circulation and the quantity of 
goods exchanged remained the same. Then, since the equa- 
tion of exchange must continue to hold true, it would be 
quite impossible for prices to remain unchanged. The 
money side would now be $10,000,000 X 20 times a year, or 
$200,000,000 ; whereas, if prices should not change, the 
goods would remain $100,000,000 and the equation would 
be violated. Since exchanges, individually and collectively, 
always involve an equivalent quid pro quo, the two sides 
must be equal. Not only must purchases and sales be equal 
in amount — since every article bought by one person is 
necessarily sold by another — but the total value of goods 
sold must equal the total amount of money exchanged. 
Therefore, under the given conditions, prices must change 
in such a way as to raise the goods side from $100,000,000 
to $200,000,000. This doubling may be accomplished by 
an even or an uneven rise of prices, but some sort of a rise 
of prices there must he. If the prices rise evenly, they will 
evidently all be exactly doubled, so that the equation 
will read : — 

$10,000,000 X 20 = 200,000,000 loaves X $ .20 per loaf 
+ 10,000,000 tons X 10.00 per ton 
-f 30,000,000 yards X 2.00 per yard. 



Sec. 3] PURCHASING POWER OF MONEY 155 

If the prices rise unevenly, the doubling must evidently be 
brought about by compensation ; if some prices rise by 
less than double, others must rise by enough more than 
double to exactly compensate. 

But whether all prices increase uniformly, each being ex- 
actly doubled, or some prices increase more and some less 
(so as still to double the total money-value of the goods pur- 
chased), the prices are doubled on the average. This proposi- 
tion is usually expressed by saying that the " general level 
of prices " is raised twofold. From the mere fact, therefore, 
that the money spent for goods must equal the quantities of 
those goods multiplied by their prices, it follows that the level 
of prices must rise or fall according to changes in the quan- 
tity of money, unless there are changes in its velocity of 
circulation or in the quantities of goods exchanged. 

If changes in the quantity of money affect prices, so will 
changes in the other factors — quantities of goods and 
velocity of circulation — affect prices. In the case of a 
change in the velocity of circulation, the change is very simi- 
lar to that seen in the case of a change in the quantity of 
money. Thus a doubling in the velocity of circulation of 
money will double the level of prices, provided the quantity 
of money in circulation and the quantities of goods ex- 
changed for money remain as before. The equation will 
change (from its original form) to the following : — 

$5,000,000 X 40 = 200,000,000 loaves X $ .20 a loaf 
+ 10,000,000 tons X 10.00 a ton 
-}- 30,000,000 yards X 2.00 a yard; 

or else the equation will assume a form in which some of 
the prices will more than double, and others less than double 
by enough to preserve the same total value of the sales. 

Again, a doubling in the quantities of goods exchanged 
will cut in two the height of the price level, provided the 
quantity of money and its velocity of circulation remain 



156 ELEMENTARY PRESTCIPLES OF ECONOMICS [Chap. VIII 

the same. Under these circumstances the equation will 
change (from its original form) to : — 

$5,000,000 X 20 = 400,000,000 loaves X $ .05 a loaf 
+ 20,000,000 tons X 2.50 a ton 
+ 60,000,000 yards X -50 a yard ; 

or else it will assume a form in which some of the prices are 
more than halved, and others less than halved, so as to 
preserve the equation. 

Finally, if there is a simultaneous change in two or all of 
the three influences, i.e., quantity of money, velocity of 
circulation, and quantities of goods exchanged, the price 
level will be a compound or resultant of these various in- 
fluences. If, for example, the quantity of money is doubled, 
and its velocity of circulation is halved, while the quantity 
of goods exchanged remains constant, the price level will be 
undisturbed. Likewise it will be undisturbed if the quan- 
tity of money is doubled and the quantity of goods is 
doubled, while the velocity of circulation remains the same. 
To double the quantity of money, therefore, does not always 
double prices. We must distinctly recognize that the 
quantity of money is only one of three factors, all equally 
important in determining the price level. 

§ 4. The Equation of Exchange Mechanically Expressed 

The equation of exchange has now been expressed by an 
arithmetical illustration. It may be represented visually by 
a mechanical illustration. This is embodied in Figure 10 
which represents a mechanical balance in equilibrium, the 
two sides of which symbolize respectively the money side 
and the goods side of the equation of exchange. The 
weight at the left, symbolized by a purse, represents the 
money in circulation ; the leverage or distance from the 
fulcrum at which the purse is hung represents the efficiency 
of this money, or its velocity of circulation. The product 



Sec. 4] 



PURCHASING POWER OF MONEY 



157 



GEZ 




I, y ' "n 




Fig. 10. 



of the weight by its leverage is exactly balanced by or 
equal to corresponding products on the opposite side. On 
the right side are three weights, representing bread, coal, 
and cloth, and symbolized respectively by a loaf, a coal 
scuttle, and a roll of cloth. The leverage, or distance of 
each from the fulcrum, represents its price. In order that 
the leverages at the right may not be inordinately long, we 
have found it convenient to reduce the unit of measure of 
coal from tons to hundredweights, and that of cloth from 
yards to feet, and consequently to enlarge correspondingly 
the number of units (the measure of coal changing from 
10,000,000 tons to 200,000,000 hundredweights, and that 
of the cloth from 30,000,000 yards to 90,000,000 feet). 
In these new units the price of coal becomes 25 cents per 
hundredweight arid that of cloth becomes 33^ cents per foot. 
If the purse at the left becomes heavier, it is evident 
that, in order to maintain the balance, some of the weights 
at the right must be heavier also or must be moved 
toward the right, or else the purse itself must be moved 
toward the right. If, now, we assume that the last and 
first of these three changes do not occur, the middle one 
must occur. In other words, if the position of the purse 
remains unaltered {i.e., if the velocity of circulation of 
money does not change) and if the weights at the right 
remain unaltered (i.e., if the volume of trade does not 
change), then some or all of these weights must move to the 
right {i.e., the prices of goods must increase). If these 
prices increase uniformly, they will increase in the same ratio 
as the increase in money ; if they do not increase uniformly, 



158 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

some will increase more and some less than this ratio, 
maintaining an average. Likewise it is evident that if the 
velocity of circulation of money increases, i.e., if the leverage 
at the left lengthens, and if the money in circulation (the 
purse) and the trade (the various weights at the right) 
remain the same, there must be an increase in prices 
(lengthening of the leverages at the right). Again, if there 
is an increase in the volume of trade (represented by an 
increase in weights at the right), and if the velocity of 
circulation of money (left leverage) and the quantity of 
money (left weight) remain the same, there must be a 
decrease in prices (right leverages). 

In general, any change in one of these four sets of mag- 
nitudes must be accompanied by such a change or changes 
in one or more of the other three as shall maintain 
equilibrium. 

As we are interested in the average change in prices 
rather than in the prices individually, we may simplify this 
mechanical representation by hanging all the right-hand 
weights at one average point, so that the leverage shall rep- 
resent the average of prices. This average, of 10 cents per 
loaf, 25 cents per hundredweight, and 33^ cents per foot, is 
found by dividing the total value (10 cents times 200 million 
loaves, plus 25 cents times 200 million hundredweight, 
plus 33I cents times 90 million feet, — or $100,000,000) 




Fig. II. 



by the total number of units (200 million plus 200 million 
plus 90 million — or 490 million), which is $100,000,000 4- 



Sec. s] PURCHASING POWER OF MONEY 1 59 

490,000,000, or 20.4 cents per unit. This leverage is a so- 
called " weighted average " of the three original leverages, the 
'' weights " being literally the weights hanging at the right. 
This averaging of prices is represented in Figure 11 
which visualizes the fact that the average price of goods 
(right leverage) varies directly with the quantity of money 
(left weight), directly with its velocity of circulation (left 
leverage), and inversely with the volume of trade (right 
weight). 

§ 5. The Equation of Exchange Algebraically Expressed 

To put these relations in general terms, let 

M stand for money in circulation, 

V, its velocity of circulation, 

p, p\ p^', etc., the prices of various goods, 

Q, Q', Q" , etc., the quantities of those goods sold. 

Then we may write the formula as follows : — 

MV = pQ 
+ PV 
+ PV 
+ etc. 

MV evidently represents the amount of money expended 
for goods during the year. On the other side of the equa- 
tion, pQ, p' Q', and so on, represent the values of the 
various goods bought. If in this equation M is doubled 
(and V and the Q's remain unchanged), then the ^'s will, 
on the average, be doubled ; if F is doubled (and M and 
the Q's are unchanged) , the p's will be doubled also ; while 
if the Q's are doubled (and M and V are unchanged), the 
^'s will be halved. 

The right side of this equation is the sum of terms of 
the form pQ — a price multiplied by a quantity bought. 
It is customary in mathematics to abbreviate a sum of 



l6o ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

terms (all of which are of the same form) by using " 2 " 
as a prefix to pQ. The Greek letter sigma is the equival- 
ent of the English letter " S," the initial letter of sum and 
is employed as a symbol of summation. This symbol does 
not signify a magnitude as do the symbols M, V, p, Q, etc. 
It signifies merely the operation of addition, and should be 
read " the sum of terms of the following type." The equa- 
tion of exchange may therefore be written : — 

MV= tpQ. 

We may, if we wish, further simplify the right side by 
writing it in the form PT, where P is a weighted average of 
all the p's, and T is the sum, of all the <2'^. P then repre- 
sents in one magnitude the level of prices, and T represents 
in one magnitude the volume of trade of the community 
within or without its borders. The equation thus simpli- 
fied {MV = PT) is the algebraic interpretation of the 
mechanical illustration given in Figure ii, where all the 
goods, instead of being hung separately, as in Figure lo, 
were combined and hung at an average point representing 
their average price. 

§6. The "Quantity Theory of Money" 

To recapitulate, we find then that, under the conditions 
assumed, the price level varies : (i) directly as the quantity 
of money in circulation {M), (2) directly as the velocity of 
its circulation ( V) , (3) inversely as the volume of trade done 
by it (r). The first of these three relations needs special 
emphasis. It constitutes the "quantity theory of money." 

So important is this principle, and so bitterly contested 
has it been, that we shall illustrate it further. By " the 
quantity of money " is meant the number of dollars (or 
other given monetary units) in circulation. This number 
may be changed in several ways, of which the four named 
below are most important. A statement of these four 



Sec. 6] PURCHASING POWER OF MONEY l6l 

will serve to picture to our mind the meaning of the con- 
clusions we have reached and to reveal the fundamental 
peculiarity of money on which they rest. 

I. As a first illustration, let us suppose the government 
to double the denominations of all money; that is, let us 
suppose that what has been hitherto a half dollar is hence- 
forth called a dollar, and that what has been hitherto a 
dollar is henceforth called two dollars. Evidently the num- 
ber of " dollars " in circulation will then be doubled ; and 
the price level, measured in terms of the new " dollars," 
will be double what it would otherwise be. Every one will 
pay out the same coins as if no such law were passed. But he 
will, in each case, be paying twice as many " dollars." For 
example, if S3 formerly had to be paid for a pair of shoes, 
the price of this same pair of shoes will now become $6. 
The proof that prices must in general be doubled rests on 
the equation of exchange. Money in circulation {M) 
having doubled (its velocity of circulation (F) and the 
volume of trade {T) remaining the same), the average 
of the prices (P) must be doubled. The same reasoning 
applies to the three illustrations which follow. 

II. For a second illustration suppose the government 
cuts each dollar in two, coining the halves into new " dol- 
lars " ; and, recalling all paper notes, replaces them with 
double the original number — two new notes for each old 
one of the same denomination. In short, suppose money 
not only to be renamed, as in the first illustration, but also 
reissued. Prices in the debased coinage will again be doubled 
just as in the first illustration. The subdivision and re- 
coinage is an immaterial circumstance, unless it be carried 
so far as to make counting difficult, and thus to interfere 
with the convenience of money. Wherever a dollar had been 
paid before debasement, two dollars — i.e., two of the old 
halves coined into two of the new dollars — will now be 
paid instead. 

In the first illustration, the increase in quantity was 



1 62 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

simply nominal, being brought about by renaming coins. 
In the second illustration, besides renaming, the further 
fact of recoining is introduced. In the first case, the num- 
ber of actual pieces of money of each kind was unchanged, 
but their denominations were doubled. In the second case, 
the number of pieces is also doubled by splitting each coin 
and reminting it into two coins, each of the same nominal 
denomination as the original whole of which it is the half, 
and by similarly doubling the paper money. 

III. For a third illustration, suppose that, instead of 
doubling the number of dollars by splitting them in two and 
recoining the halves, the government duplicates each piece 
of money in existence and presents the duplicate to the pos- 
sessor of the original. (We must in this case suppose, 
further, that there is some effectual bar to prevent the 
melting or exporting of money. Otherwise the quantity of 
money in circulation will not be doubled ; much of the in- 
crease will escape.) If the quantity of money is thus 
doubled, prices will also be doubled just as truly as in the 
second illustration, in which there were exactly the same 
number of coins as now under consideration as well as the 
same denominations. The only difference between the 
second and the third illustrations will be in the size and 
weight of the coins. The weights of the individual coins, 
instead of being reduced, will remain unchanged ; but their 
number will be doubled. This doubling of coins must have 
the same effect as the fifty per cent debasement ; that is, 
it must have the effect of doubling prices. 

IV. The force of the third illustration becomes even more 
evident if, in accordance with the presentation of the great 
economist Ricardo, we pass back by means of a seigniorage 
from the third illustration to the second. That is, after 
duplicating all money, let the government subtract half of 
each coin, thereby reducing the weight to that of the debased 
coinage in the second illustration, and removing the only 
point of distinction between the two. This " seigniorage " 



Sec. 6] PURCHASING POWER OF MONEY 1 63 

or charge for coinage made by the sovereign will not affect 
the money value of the coins, so long as their number remains 
unchanged. Prices will remain at exactly the same level as 
before the abstraction of seigniorage. 

Thus to double the quantity of money will double prices 
in whatever way the doubling may be brought about, — 
unless there should occur at the same time some change 
in the velocity of circulation of money or in the volume 
of trade. 

The student may ask whether some change in the 
velocity of circulation of money or in the volume of trade 
will not necessarily occur as a direct consequence of the 
increased quantity of money. The answer to this 
question is in the negative, but this answer wUl be better 
understood after we have seen on what causes velocity of 
circulation and volume of trade depend. In the present 
chapter we are concerned merely to show that an increase 
in money will necessitate a rise in prices provided the 
velocity of circulation and volume of trade do remain the 
same. 

There are many historical instances of raising the prices 
by inflating the currency. At present, Argentina has an 
inflated paper currency, and prices in paper pesos are a 
little more than double the prices in the original gold pesos. 

The quantity theory, then, asserts that (provided ve- 
locity of circulation and volume of trade are unchanged) 
if we increase the number of dollars, whether by renaming 
coins, by cutting them in two, by duplicating them, or by 
any other means, prices will be increased in the same pro- 
portion. It is the number, and not the weight, that is 
essential. This fact needs great emphasis. It is a fact 
which differentiates money from all other goods and ex- 
plains the peculiar manner in which its purchasing power 
is related to other goods. The desirability of sugar depends 
upon its sweetening power, which is a specific quality in 
the sense that a given weight of sugar, such as a pound, 



164 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. VIII 

always possesses the same sweetening power. The desir- 
ability of money, on the other hand, depends merely on its 
purchasing power; but purchasing power is not a specific 
quality of gold or of other money, for we cannot say that a 
given quantity of gold, such as an ounce, always possesses 
the same purchasing power. If the quantity of sugar is 
changed from 1,000,000 pounds to 1,000,000 hundredweight, 
it does not follow that a hundredweight will have the value 
previously possessed by a pound, for the sweetening power 
of a hundredweight cannot be the same as that of a pound. 
But if the money in circulation is changed from 1,000,000 
units of one weight to 1,000,000 units of a lighter weight, 
the value of the new and lighter coins wUl be just as great 
as was the value of the old and heavy ones, for we have 
seen from the equation of exchange that their purchasing 
power will be unchanged. 

The quantity theory of money thus rests, ultimately, 
upon the fundamental peculiarity which money alone of all 
goods possesses — the fact that it has no definite relation 
to the satisfaction of human wants, but only the power to 
purchase things which do have such satisfying power. 



CHAPTER IX 

INrLUENCE OF DEPOSIT CURRENCY 

§ I. The Mystery of Circulating Credit 

We are now ready to explain the nature of bank-deposit 
currency, or circulating credit. Credit, in the sense here 
employed, is the promise of one party (called the debtor) 
to pay money to another party (called the creditor). 
Bank deposits subject to check are the claims against the 
bank of a special class of creditors known as depositors, 
by virtue of which they may, on demand, draw by check 
specified sums of money from the bank. Since no other 
kind of bank deposits will be considered by us, we shall 
usually refer to " bank deposits subject to check " simply 
as " bank deposits." They are also called " circulating 
credit." 

It is to be observed that bank checks are merely 
presumptive evidences of rights to draw money on the 
basis of bank deposits or to transfer such rights. The 
checks themselves are not the ultimate currency. It is 
the bank deposits themselves, or credit balances on the 
books of the banks, that constitute the ultimate currency. 
As has been noted, these deposits subject to check are not 
money, since they are not generally acceptable ; they always 
require the special consent of the payee. But they are cur- 
rency, because their chief purpose and use is to act as a 
medium of exchange. Closely analogous to checks are post 

i6s 



1 66 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

office orders and money orders issued by express companies. 
They are distinguishable only by two facts : that they are 
not issued by ordinary banks, and that they originate in 
special deposits of money (or checks) . For this reason, and 
because they are not of great importance, we prefer to 
place them in the same category with bank checks rather 
than to place them in a separate class, which otherwise 
they might occupy. 

It is in connection with the transfer of bank deposits 
that there arises that so-called " mystery of banking " 
called circulating credit. Many persons, including some 
economists, have supposed that credit is a special form of 
wealth which may be created out of whole cloth, as it were, 
by a bank. Others have maintained that credit has no 
foundation in actual wealth at all, but is a kind of unreal 
and inflated bubble with a precarious if not wholly illegiti- 
mate existence. As a matter of fact, bank deposits are as 
easy to understand as bank notes, and what is said in this 
chapter of bank deposits may in substance be taken as true 
also of bank notes. The chief difference is a formal one, 
the notes circulating freely from hand to hand, while the 
deposit currency circulates only by means of specially in- 
dorsed orders called " checks." 

To understand the real nature of bank deposits, let us 
imagine a hypothetical institution — a kind of primitive 
bank existing mainly for the sake of deposits and the safe- 
keeping of actual money. The original bank of Amster- 
dam was somewhat like the bank we are now imagining. 
In such a bank a number of people deposit $100,000 in gold, 
each accepting a receipt for the amount of his deposit. If 
this bank should issue a " capital account " or statement, 
it would show $100,000 in its vaults and $100,000 owed to 
depositors, as follows : — 

Assets Liabilities 

Gold $100,000 Due depositors . . $100,000 



Sec. i] influence OF DEPOSIT CURRENCY 1 67 

The right-hand side of the statement is, of course, made 
up of smaller amounts owed to individual depositors. 
Assuming that there is owed to A $10,000, to B $10,000, 
and to all others $80,000, we may write the bank statement 
as follows : — 

Assets Liabilities 

Gold $100,000 Due depositor A . . $ 10,000 

Due depositor B . . 10,000 
Due other depositors . 80,000 



$100,000 



Now assume that A wishes to pay B $1000. A could go 
to the bank with B, present certificates or checks for $1000, 
obtain the gold, and hand it over to B, who might then 
redeposit it in the same bank, merely handing it back 
through the cashier's window and taking a new certificate 
in his own name. Instead, however, of both A and B 
visiting the bank and handling the money, A might simply 
give B a check for $1000. B would then send the check 
to the bank and the bank would simply reduce A's credit 
on its books by $1000 and increase B's by the same 
amount. The transfer in either case would mean that 
A's holding in the bank was reduced from $10,000 to $9000, 
and that B's was increased from $10,000 to $11,000. The 
statement would then read : — 

Assets Liabilities 

Gold $100,000 Due depositor A . . $ 9,000 

Due depositor B . . 11,000 

Due other depositors . 80,000 

$100,000 $100,000 

Thus the certificates, or checks, would circulate in place 
of money among the various depositors in the bank. What 
really changes ownership, or " circtdates,^' in such cases is the 
right to draw money. The check is merely a presumptive 
evidence of this right and of the transfer of this right from 



1 68 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

one person to another. The man who receives the check 
uses it as evidence of a right to draw at the bank against 
the account of the man who drew the check. 

In the case under consideration, the bank would be con- 
ducted at a loss. It would be giving the time and labor 
of its clerical force for the accommodation of its depositors, 
without getting anything in return. But such a hypo- 
thetical bank would soon find — much as did the bank of 
Amsterdam — that it could make profits by lending at 
interest some of the gold on deposit. This could not offend 
the depositors; for they do not expect or desire to get 
back the identical gold they deposited. What they want 
is simply to be able at any time to obtain the same amount 
of gold. Since, then, their arrangement with the bank calls 
for the payment not of any particular gold, but merely of 
a definite amount, and that but occasionally, the bank 
finds itself free to lend out part of the gold that otherwise 
would lie idle in its vaults. To keep it idle would be a 
great and needless waste of opportunity. 

Let us suppose, then, that the bank decides to loan out 
half the money which it has in its vaults. In this country 
this is usually done in exchange for promissory notes of 
the borrowers. Now a loan is really an exchange of money 
(or credit — which is immediately convertible into money) 
for a promissory note which the lender — in this case the 
bank — receives in place of the gold. Let us suppose that 
so-called borrowers actually draw out $50,000 of gold. 
The bank thereby exchanges this money for promises, and 
its books will then read : — 

Assets Liabilities 

Gold % 50,000 Due depositor A . . $ 9,000 

Promissory notes . . 50,000 Due depositor B . . 11,000 

Due other depositors . . 80,000 

$100,000 $100,000 

It will be noted that now the gold in bank is only $50,000, 



Sec. i] 



INFLUENCE OF DEPOSIT CURRENCY 



169 



while the total deposits are still $100,000. In other words, 
the depositors now have more " money on deposit " than 
the bank has in its vaults ! But, as will be shown, this 
form of expression involves a popular fallacy, in the word 
" money." Something of equivalent value is behind each 
loan, but not necessarily money. 

Next, suppose the borrowers become, in a sense, lenders 
also, by redepositing the $50,000 of money which they bor- 
rowed, in return for the right to draw out the same sum on 
demand, preferring to use the same in making payments 
by check rather than by money. In other words, suppose 
that after borrowing $50,000 from the bank, they lend it 
back to the bank. The bank's assets will thus be en- 
larged by $50,000, and its obligations (or credit extended) 
will be equa>lly enlarged; and the balance sheet will 
become : — 



Assets 

Gold 

Promissory notes . 



F 1 00,000 
50,000 



$150,000 



Liabilities 
Due depositor A . 
Due depositor B . 
Due other depositors 
Due new depositors 
i.e., the borrowers 



* 9.000 
11,000 
80,000 

50,000 
$150,000 



What happened in this case was the following : Gold 
was borrowed in exchange for a promissory note and then 
handed back in exchange for a right to draw. Thus the 
gold really did not budge ; but the bank received a promis- 
sory note and the depositor, a right to draw. Evidently, 
therefore, the same result would have followed if each bor- 
rower had merely handed in his promissory note and re- 
ceived, in exchange, a right to draw. As this operation 
most frequently puzzles the beginner in the study of bank- 
ing, we repeat the tables representing the conditions before 
and after these ** loans," i.e., these exchanges of promissory 
notes for present rights to draw. 



170 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

BEFORE THE LOANS 

Assets Liabilities 

Gold $100,000 Due depositors . . . $100,000 

AFTER THE LOANS 

Gold $100,000 Due depositors . . . $150,000 

Promissory notes . . 50,000 

Clearly, therefore, the intermediation of the money in 
this case is a needless compHcation, though it may help to 
a theoretical understanding of the resultant shifting of 
rights and liabilities. Thus the bank may receive deposits of 
gold or deposits of promises to pay. In exchange for these 
promises it may give, or lend, either a right to draw, or 
gold — the same that was deposited by another customer. 
Even when the borrower has " deposited " only a promise 
to pay money, by fiction he is still held to have deposited 
money; and, like the original depositor of actual money, 
he is given the right to make out checks to draw out money. 
The total value of rights to draw, in whichever way arising, 
is termed "deposits." Banks more often lend rights to draw 
(or deposit-rights) than actual money, partly because of the 
greater convenience to borrowers, and partly because the 
banks wish to keep their actual money on hand, or " cash 
reserves " large, in order to meet large and unexpected 
demands. It is true that if a bank loans money, part of 
the money so loaned will be redeposited by the persons 
to whom the borrowers pay it in the course of business; 
but it will not necessarily be redeposited in the same bank. 
Hence the average banker prefers that the borrower should 
not withdraw actual money. 

Besides lending deposit rights, banks may also lend their 
own notes, called " bank notes." And the principle govern- 
ing bank notes is the same as the principle governing 
deposit rights. The holder simply gets a pocketful of bank 
notes instead of a credit on his bank account. The bank 



Sec. 2] INFLUENCE OF DEPOSIT CURRENCY 171 

must always be ready to pay, on demand, either the note 
holders — i.e., to " redeem its notes " — or the depositors, 
and in either case the bank exchanges a promise for a 
promise. In the case of the note, the bank has exchanged 
its bank note for a customer's promissory note. The bank 
note carries no interest, but is payable on demand. The 
customer's note bears interest, but is payable only at a 
definite date. 

Assuming that the bank issues $50,000 of bank notes, the 
balance sheet will now become : — 

Assets Liabilities 

Gold $100,000 Due depositors . . $150,000 

Loans (promissory- 
notes) 100,000 Due bank note holders 50,000 

$200,000 $200,000 

§ 2. The Basis of Circulating Credit 

We repeat that by means of credit the deposits and notes 
of a bank may exceed its cash. There would be nothing 
mysterious or obscure about this fact, if people could be 
induced not to think of banking operations as money 
operations. To so represent them is metaphorical and 
misleading. They are no more money operations than 
they are real estate transactions. A bank depositor. A, 
has not ordinarily " deposited money " ; and whether he 
has or not, he certainly cannot properly say that he " has 
money in the bank." What he does have is the bank's 
promise to pay money on demand. The bank owes him 
money. When a private person owes money, the creditor 
never thinks of saying that he has it on deposit in the 
debtor's pocket. 

The same principles of property which apply to bank 
deposits also apply to bank notes. There is wealth some- 
where behind the mutual promises, though in different 
degrees of accessibility. The note holder's promise (his 



172 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

promissory note) is secured by his assets ; and the bank's 
promise (the bank note) is secured by the bank's assets. 
The note holder has " swapped " less-known credit for 
better-known credit. 

If this fact is borne in mind, the reader will be able to 
conquer the doubt which may already have arisen in his 
mind — the doubt as to the legitimacy of the bank's pro- 
cedure in " lending some of its depositors' money." It 
cannot be too strongly emphasized that, in any balance 
sheet, the value of the liabilities rests on that of the assets. 
The deposits of a bank are no exception. We must not be 
misled by the fact that the cash assets may be less than 
the deposits. When the uninitiated first learn that the 
number of dollars which note holders and depositors have 
the right to draw out of a bank exceeds the number of 
dollars in the bank, they are apt to jump to the conclusion 
that there is nothing behind the notes or deposit liabilities. 
Yet behind all these obligations there is always, in the case 
of a solvent bank, full value ; if not actual dollars, at any 
rate, dollars^ worth of property. By no jugglery can the 
liabilities exceed the assets except in insolvency, and even 
in that case only nominally, for it still holds that the true 
value of the liabilities will be only what can be paid on 
them — perhaps only 25 cents on the dollar. This true 
value of the liabilities will rest upon and be equal to the 
true value of the assets behind them by means of which 
they will be paid, so far as may be. Debts which cannot 
or will not be paid in full are often called '' bad debts " ; 
and the value of "bad debts " is not their face value, but 
their actual value to the creditor. 

These assets, as already indicated, are, and ought to be, 
largely the notes of merchants, although, so far as the prin- 
ciples here discussed are concerned, they might be any 
property whatever. If they consisted in the ownership 
of real estate or other wealth unencumbered so that the 
tangible wealth which property always represents were 



Sec. 2] INFLUENCE OF DEPOSIT CURRENCY 1 73 

clearly evident, all mystery would disappear. But the 
effect would not be different. Instead of taking grain, 
machines, or steel ingots on deposit, in exchange for the 
sums lent, banks prefer to take interest-bearing notes of 
corporations and individuals who own, directly or indirectly, 
grain, machines, and steel ingots ; and by the banking laws 
the banks are even compelled to take the notes instead of 
the ingots. The bank finds itself with liabilities which 
exceed its cash assets ; but this excess of liabilities is balanced 
by the possession of other assets than cash. These other 
assets of the bank are the liabilities of business men. 
These liabilities are in turn supported by the assets of the 
business men. If we continue to follow up the chain of 
liabilities and assets, we shall find the ultimate basis of 
the bank's liabilities in the concrete tangible wealth of the 
world. 

This ultimate basis of the entire credit structure is kept 
out of sight, but the basis exists. Indeed, we may say that 
banking, in a sense, causes this concrete, tangible wealth to 
circulate. If the acres of a landowner or the iron stoves of 
a stove dealer cannot circulate in literally the same way 
that gold dollars circulate, yet the landowner or stove 
dealer may give to the bank a note on which the banker 
may base bank notes or deposits ; and these bank notes and 
deposits will circulate like gold dollars. Through banking, 
he who possesses wealth difiicult to exchange can create a 
circulating medium based upon that wealth. He has only to 
give his note, for which, of course, his property is liable, get 
in return the right to draw, and lo ! his comparatively 
unexchangeable wealth becomes liquid currency. To put it 
crudely, deposit banking is a device for coining into dol- 
lars land, stoves, and other wealth not otherwise generally 
exchangeable. 

We began by regarding a bank as substantially a coopera- 
tive enterprise, operated for the convenience and at the ex- 
pense of its depositors. But, as soon as the bank reaches 



174 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. IX 

the point of lending money to X, Y, and Z on time, while 
itself owing money on demand, it assumes toward X, Y, 
and Z risks which the depositors would be unwilKng to 
assume. To meet this situation, the responsibility and 
expense of running the bank are taken by a third class of 
people — stockholders — who are willing to assume the 
risk for the sake of the chance of profit. Stockholders, in 
lOrder to guarantee the depositors against loss, put in some 
cash of their own. The object is to make good any loss 
to depositors, while reserving the right to keep the profits 
earned by loaning at interest. Let us suppose that the 
stockholders put in $50,000, \dz., $40,000 in gold and $10,000 
in the purchase of a bank building. The accounts now 
stand : — 

Assets Liabilities 

Gold $140,000 Due depositors . . $150,000 

Loans 100,000 Due note holders . . 50,000 

Building 10,000 Due stockholders . . 50,000 

$250,000 $250,000 

The accounts as they now stand include the chief features 
of an ordinary modern bank — a so-called " bank of deposit, 
issue, and discount." 

§ 3. Banking Limitations 

We have seen that there are assets to meet the liabilities. 
We now should note that the form of the assets must be 
such as will insure meeting the liabilities promptly. Since 
the business of a bank is to furnish easily exchangeable 
property (cash or credit) in place of the " slower " prop- 
erty of its depositors, it fails of its purpose when it is 
caught with insufficient cash, by which is meant money. 
Yet it makes profits partly by tying up its quick property, 
i.e., lending it out in quarters where it is less accessible. 
Its problem in policy is to tie up enough to increase its 



Sec. 3] INFLUENCE OF DEPOSIT CURRENCY 1 75 

earnings, but not to tie up so much as to get tied up itself. 
So far as anything has yet been said to the contrary, a 
bank might increase indefinitely its loans in relation to its 
cash or in relation to its capital. If this were so, deposit 
currency could be indefinitely inflated. 

There are, however, Hmits to such expansion of loans 
imposed by prudence and sound economic policy. Insol- 
vency and insufficiency of cash must both be avoided. As 
has been noted in Chapter III, § 5, insolvency is that condi- 
tion which threatens when Habilities are extended with in- 
sufficient capital. Insufficiency of cash is that condition 
which threatens when liabilities are extended unduly rela- 
tively to cash. Insolvency is reached when the assets 
no longer cover the liabilities (to others than stockholders) , 
so that the bank is unable to pay its debts. Insufficiency 
of cash is reached when, although the bank's total assets 
may be fully equal to its liabilities, the actual cash on 
hand is insufficient to meet the needs of the instant, and 
the bank is unable to pay its debts on demand. 

The risk of insolvency is the greater . the less the ratio 
of the stockholders' interests to all liabilities to others. The 
risk of insufficiency of cash is the greater, the less the ratio 
of the cash to the demand liabilities. In other words, the 
leading safeguard against insolvency lies in a large capital 
and surplus, but the leading safeguard against insufficiency 
of cash lies in a large cash reserve. Insolvency proper 
may befall any business enterprise. Insufficiency of cash 
relates especially to banks in their function of redeeming 
notes and deposits. 

Let us illustrate insufficiency of cash. In our bank's 
accounts as we left them there appeared cash to the extent 
of $140,000, and $200,000 of demand liabilities (deposits and 
notes). The managers of the bank may think this fund of 
$140,000 unnecessarily large, or the loans unnecessarily 
small. They may then increase their loans (extended to 
customers partly in the form of cash and partly in the form 



176 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

of deposit accounts) until the cash held by the bank is re- 
duced, say to $40,000, and the liabilities due depositors and 
note holders increased to $300,000. If, under these circum- 
stances, some depositor or note holder demands $50,000 
cash, immediate payment will be impossible. It is true that 
the assets still equal the liabilities. There is full value be- 
hind the $50,000 demanded ; but the understanding was 
that depositors and note holders should be paid in money on 
demand. Were this not a stipulation of the deposit con- 
tract, the bank might pay the claims thus made upon it by 
transferring to its creditors the promissory notes due it from 
its debtors ; or it might ask the customers to wait until it 
could turn these securities into cash. 

Since a bank cannot follow either of these plans, it tries, 
where insufficiency of cash impends, to forestall this condi- 
tion by " calling in " some of its loans, or if none can be 
called in, by selling some of its securities or other property 
for cash. But it happens unfortunately that there is a limit 
to the amount of cash which a bank can suddenly realize. 
No bank could escape failure if a large percentage of its note 
holders and depositors should simultaneously demand cash 
payment. The paradox of a run on a bank is well expressed 
by the case of the man who inquired of his bank whether it 
had cash available for paying the amount of his deposit, 
saying, " If you can pay me, I don't want it ; but if you 
can't, I do." Such was the situation in 1907 in Wall Street. 
All the depositors at one time wanted to be sure their money 
" was there." Yet it never is there all at one time. 

Since, then, insufficiency of cash is so troublesome a con- 
dition — so difficult to escape when it has arrived, and so 
difficult to forestall when it begins to approach — a bank 
must so regulate its loans and note issues as to keep on hand 
a sufficient cash reserve, and thus prevent insufficiency of 
cash from even threatening. It can regulate the reserve in 
various ways. For instance, it can increase its reserve rela- 
tively to its liabilities by " discounting" less freely — by 



Sec. 3] INFLUENCE OF DEPOSIT CURRENCY 1 77 

raising the rate of discount and thus discouraging would-be 
borrowers, by outright refusal to lend or even to renew old 
loans, or by " calling in " loans subject to call. Reversely, 
it can decrease its reserve relatively to its liabilities by dis- 
counting more freely — by lowering the rate of discount 
and thus attracting borrowers. The more the loans in pro- 
portion to the cash on hand, the greater the profits, but the 
greater the danger also. In the long run a bank maintains 
its necessary reserve by means of adjusting the interest rate 
charged for loans. If it has few loans, and a reserve large 
enough to support loans of much greater volume, it will 
endeavor to extend its loans by lowering the rate of interest. 
If its loans are large, and it fears too great demands on the 
reserve, it will restrict the loans by a high interest charge. 
Thus by alternately raising and lowering the rate of interest, 
a bank keeps its loans within the sum which the reserve can 
support, but endeavors to keep them (for the sake of profit) 
as high as the reserve will support. 

If the sums owed to individual depositors are large, rela- 
tively to the total liabilities, the reserve should be propor- 
tionately large, since the action of a small number of deposi- 
tors can deplete it rapidl)^ The reserve in a large city of 
great banking activity needs to be greater in proportion to 
its demand liabilities than in a small town with infrequent 
banking transactions. No absolute numerical rule can be 
given. Arbitrary rules are often imposed by law. Banks 
in the United States, for instance, are required to keep a 
ratio of reserve to deposits, varying from twelve and a half 
per cent to twenty-five per cent, according as they are state 
or national banks, and according to their location. For 
the whole country the reserves in banks are about one 
fifth of the deposits. These reserves are all in defense of 
deposits. In defense of bank notes, which are issued only 
by national banks, the method of protection is different. 
True, the same economic principles apply to both bank notes 
and deposits, but the law treats them differently. The gov- 



y 



178 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

ernment itself chooses to undertake to redeem the national 
bank notes on demand, imposing on the banks certain obli- 
gations to deposit with itself a redemption fund and govern- 
ment bonds. 

As previously stated the cash reserves of banks, though 
money, are not, properly speaking, money in circulation. 
The reason is that they are not held for the purchase of 
goods, but for the redemption of another kind of currency 
— deposits. Thus the money in any society is divided 
into two chief parts ; money in circulation and money in 
banks. In the United States these two are approximately 
equal, both being about one and a half billion dollars.-^ 

§ 4. The Total Currency and its Circulation 

The study of banking operations, then, discloses two 
species of bank currency : one, bank notes, belonging to the 
category of money ; and the other, deposits, belonging out- 
side of that category but constituting an excellent substi- 
tute. Referring these to the larger category of goods, we 
have a threefold classification of goods : first, money; second, 
deposit currency, or sim^ply deposits; and third, all other 
goods. Among these, then, there are six possible types of 
exchange : — 

. (i) Money against money, 

(2) Deposits against deposits, 

(3) Goods against goods, 

. (4) Money against deposits, 
' (5) Money against goods, 
(6) Deposits against goods. 

For our purpose, only the last two types of exchange are 
important, for these constitute the circidation of currency. 

'^ In the United States there is a third though smaller stock of money, 
the hoard in the United States Treasury, amounting at present to about 
a third of a billion of dollars. In other countries the government money 
is usually almost all deposited in banks. 



Sec. 4] INFLUENCE OF DEPOSIT CURRENCY 1 79 

As regards the other four, the first and third have been pre- 
viously explained as " money changing " and " barter," 
respectively. The second and fourth are banking trans- 
actions : the second being such operations as the selling of 
drafts for checks or the mutual cancellation of bank clear- 
ings ; and the fourth being such operations as the depositing 
or withdrawing of money, by depositing cash or cashing 
checks. 

The analysis of the balance sheets of banks has prepared 
us for the inclusion of bank deposits or circulating credit in 
the equation of exchange. We shall still use M to express 
the quantity of actual money, and V to express the velocity 
of its circulation. Similarly, we shall now use M^ to express 
the total deposits subject to transfer by check ; and V' to 
express the average velocity of their circulation. The total 
value of purchases in a year is therefore no longer to be 
measured by MV^ but hy MV -\- M'V' . The equation of 
exchange, therefore, becomes 

MV + M'V' = ^pQ, = PT. 

Let us again represent the equation of exchange by means 
of a mechanical picture. In Figure 12, trade, as before, is 
represented on the right by the weight of a miscellaneous 



Fig. 12. 

assortment of goods ; and their average price by the distance 
to the right from the fulcrum, or the leverage at which 
this weight hangs. Again at the left, money {M) is repre- 
sented by a weight in the form of a purse, and its velocity of 
circulation ( V) by its leverage ; but now we have a new 
weight at the left, in the form of a bank book, to represent 



l8o ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

the bank deposits {M'). The velocity of circulation {V') 
of these bank deposits is represented by its distance from 
the fulcrum or the leverage at which the book hangs. 

This mechanism makes clear the fact that the average 
price (right leverage) increases with the increase of money or 
bank deposits and with the velocities of their circulation, 
and decreases with the increase in the volume of trade. 

Recurring to the left side of the equation of exchange, 
or MV -\- M'V ,we see that in a community without bank 
deposits the left side of the equation reduces simply to 
MV, the formula of Chapter VIII ; for in such a community 
the term M' V' vanishes. The introduction of M' tends to 
raise prices ; that is, the hanging of the bank book on the 
left requires a lengthening of the leverage at the right. 

§ 5. Deposit Currency Normally Proportional to Money 

With the extension of the equation of monetary circula- 
tion to include deposit circulation, the influence exerted by 
the quantity of money on general prices becomes less direct ; 
and the process of tracing this influence becomes more diffi- 
cult and complicated. It has even been argued that this 
interposition of circulating credit breaks whatever connec- 
tion there may be between prices and the quantity of money. 
This would be true if circulating credit were independent of 
money. But the fact is that the quantity of circulating 
credit, M' , tends to hold a definite relation to M, the quan- 
tity of money in circulation ; that is, deposits are normally 
a more or less definite multiple of money. 

Two facts normally give deposits a more or less definite 
ratio to money. The first has been already explained, viz., 
that bank reserves are kept in a more or less definite ratio 
to bank deposits. The second is that individuals, firms, 
and corporations preserve more or less definite ratios between 
their cash transactions and their check transactions, and also 
between their money and deposit balances. These ratios 



Sec. 5] INFLUENCE OF DEPOSIT CURRENCY 181 

are determined by motives of individual convenience and 
habit. In general, business firms use money for wage pay- 
ments, and for small miscellaneous transactions included 
under the term " petty cash " ; while for settlements with 
each other they usually prefer checks. These preferences 
are so strong that we could not imagine them overridden 
except temporarily, and to a small degree. A business firm 
would hardly pay car fares with checks and liquidate its 
large liabilities with cash. Each person strikes an equilib- 
rium between his use of the two methods of payment, and 
does not greatly disturb it except for short periods of time. 
He keeps his stock of money or his bank balance in constant 
adjustment to the payments he makes in money or by check. 
Whenever his stock of money becomes relatively small and 
his bank balance relatively large, he cashes a check. In 
the opposite event, he deposits cash. In this way he is 
constantly converting one of the two media of exchange into 
the other, A private individual usually feeds his purse from 
his bank account ; a retail commercial firm usually feeds its 
bank account from its till. The bank acts as intermediary 
for both. 

Another reason why money and checks each have sepa- 
rate spheres, tending at any given time to maintain a fairly 
definite relation to each other, is that they are used in 
definitely different ways by different classes. Thus wage 
earners for the most part use only money, while the pro- 
fessional and propertied classes and the fictitious persons 
(corporations, partnerships, etc.) use mostly checks. At 
present probably over half of the families in the United 
States use no checks. 

For any one individual the adjustment of cash-in- 
pocket to deposits-in-bank will be extremely rough ; for 
sometimes the one or the other will be much too large or 
too small. But, for the community as a whole, the ad- 
justment of the cash to deposits used will be very deli- 
cate; for the temporary aberrations of many thousands 



l82 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. IX 

of individuals will ordinarily almost completely neutralize 
each other. 

In a given community the quantitative relation of deposit 
currency to money is determined by several considerations 
of convenience. In the first place, the more highly devel- 
oped the business of a community, the more prevalent the 
use of checks. Where business is conducted on a large scale, 
merchants habitually transact their larger operations with 
each other by means of checks, and their smaller ones by 
means of cash. Again, the more concentrated the popula- 
tion, the more prevalent the use of checks. In cities it is 
more convenient both for the payer and the payee to make 
large payments by check ; whereas, in the country, trips to 
a bank are too expensive in time and effort to be conven- 
ient, and therefore more money is used in proportion to the 
amount of business done. Again, the wealthier the members 
of the community, the more largely will they use checks. 
Laborers seldom use them ; but capitalists, professional and 
salaried men, use them habitually, for personal as well as 
business transactions. 

There is, then, a relation of convenience and custom be- 
tween check and cash circulation, and a more or less stable 
ratio between the deposit balance of the average man or 
corporation and the stock of money kept in pocket or till. 
This fact, as applied to the country as a whole, means 
that by convenience a fairly definite ratio is fixed be- 
tween M and M'. If that ratio is disturbed temporarily, 
there will come into play a tendency to restore it. Indi- 
viduals will deposit surplus cash, or they will cash surplus 
deposits. 

Hence, both money in circulation (as shown above) and 
money in reserve (as shown previously) tend to keep in a 
fixed ratio to deposits. It follows that the two must be in a 
more or less definite, though elastic, ratio to each other. 



Sec. 6] INFLUENCE OF DEPOSIT CURRENCY 1 83 

§ 6. Summary 

The contents -of this chapter may be formulated in a few 
simple propositions : — 

(i) Banks supply two kinds of currency, viz., bank notes 

— which are money ; and bank deposits (or rights to draw) 

— which are not money. 

(2) A bank check is merely presumptive evidence of a 
right to draw. 

(3) Behind the claims of depositors and note holders 
stand, not simply the cash reserve, but all the assets of the 
bank. 

(4) Deposit banking is a device by which wealth, inca- 
pable of direct circulation, may be made the basis of the 
circulation of rights to draw. 

(5) The basis of such circulating rights to draw or de- 
posits must consist in part of actual money, and it should 
consist in part also of quick assets readily exchangeable for 
money. 

(6) Six sorts of exchange exist among the three classes of 
goods, money, deposits, and other goods. Of these six 
sorts of exchange, the most important for our present pur- 
poses are the exchanges of money and deposits against other 
goods. 

(7) The equation of money circulation, extended so as to 
make it include bank deposits, reads thus: MV -\- M'V 
= ^pQ = PT. 

(8) Bank deposits {M') tend to keep a normal ratio to 
bank reserves and to the quantity of money (M) ; because, 
in the first place, cash reserves are necessary to support 
bank deposits, and these reserves must bear some more or 
less constant ratio to the amount of such deposits ; and 
because, in the second place, business convenience dictates 
that the circulating medium or currency shall be appor- 
tioned between deposits and money in a certain more or 
less definite, even though elastic, ratio. 



CHAPTER X 

CAUSES AND EFFECTS OF PURCHASING POWER DURING TRANSI- 
TION PERIODS 

§ I. Transition Periods 

In the preceding chapter it was shown that the quantity 
of bank deposits normally maintains a more or less definite 
ratio to the quantity of money in circulation and to the 
amount of bank reserves. As long as this normal relation 
holds, the existence of bank deposits merely magnifies the 
effect on the level of prices produced by the quantity of 
money in circulation and does not in the least distort that 
effect. IMoreover, changes in velocity or trade will have the 
same kind of effect on prices, whether bank deposits are 
included or not. 

But during periods of transition this relation between 
money {M) and deposits {M') is by no means rigid. By 
a period of transition is meant the interval of time during 
which a disturbance in any of the six magnitudes in the 
equation of exchange (for instance, an increase in the quantity 
of money in circulation) works out its effects. It takes time 
for any such disturbance to completely work out its results, 
just as it takes time after a locomotive engineer has put 
on more steam for the full effects to be felt by the train 
which is drawn. There is always a transition period which 
must elapse before any new cause completes its influence, 
and, during this transition period, the effects are somewhat 

184 



Sec. i] transition PERIODS 1 85 

different from the final result after the transition period is 
over. Thus, though the final result of suddenly putting on 
the increased steam will be to increase the speed of the train 
from thirty miles per hour to forty miles per hour, this effect 
will not be felt immediately. There will be a transition 
period of several minutes before this speed is attained. Dur- 
ing this transition period the speed will gradually increase, 
the couplings will expand and then contract, the passengers 
will feel jolted, and so forth. After the transition period 
is over, the train will run smoothly again. 

We are now ready to study periods of transition for the 
equation of exchange. Our concern is with rising or falling 
prices. Rising prices mark the transition between a lower 
and a higher level of prices, just as a hill marks the transi- 
tion between flat lowlands and flat highlands. 

The study of these acclivities and declivities is bound up 
with the study of business loans. Now when prices are 
rising borrowers are benefited and lenders injured, while 
when prices are falling the opposite is true. It must be 
borne in mind that although business loans are made in the 
form of money, yet whenever a man borrows money he 
does not do this in order to hoard the money, but to 
purchase goods with it. Suppose A borrows $100 from B. 
What has really been borrowed is purchasing power. If 
at the end of a year A returns $100 to B, but prices have 
meanwhile advanced, then B has lost a fraction of the pur- 
chasing power originally loaned to A. Even though A 
should happen to return to B the identical coins in which 
the loan was made, these coins represent somewhat less than 
the original quantity of purchasable commodities. Bearing 
this in mind, let us suppose that prices are rising. Then 
every lender will lose by the rise in prices unless he can safe- 
guard himself against this loss by making sufficiently hard 
terms with the borrower. Usually, however, when prices are 
about to rise, neither the lender nor the borrower fully realizes 
that prices are going to rise as much as they actually do. 



1 86 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. X 

§ 2. How a Rise of Prices Generates a Further Rise 

We are now ready to study temporary or transitional 
changes in the factors of our equation of exchange. Let us 
begin by assuming a sHght initial disturbance, such as would 
be produced, for instance, by an increase in the quantity 
of gold. This, through the equation of exchange, will cause 
a rise in prices. As prices rise, profits of business men 
measured in money will rise also, even if the costs of business 
were to rise in the same proportion. Thus, if a man who 
sold goods for $10,000 which cost $6000, clearing $4000, 
could get double prices at double cost, his profit would 
double also, being $20,000 — $12,000, which is $8000. Of 
course, such a rise of profits would be purely nominal, as it 
would merely keep pace with the rise in price level. The 
business man would gain no advantage, for his larger money 
profits would buy no more than his former smaller money 
profits bought before. But, as a matter of fact, the busi- 
ness man's profits will usually rise more than this, because 
many of his expenses will tend to remain the same. In 
particular his payments to creditors for past loans and his 
payments to employees for work will for a time remain 
unaffected or little affected by the general rise in prices. 
Consequently, he will find himself making greater profits 
than usual, and be encouraged to expand his business by 
increasing his borrowings. These borrowings are mostly 
in the form of short-time loans from banks ; and, as we have 
seen (Chapter IX, § i), short-time loans engender deposits. 
Therefore, deposit currency {M') will increase. But this 
extension of deposit currency tends further to raise the 
general level of prices, just as the increase of gold raised it 
in the first place. This further rise of prices enables bor- 
rowers who are now receiving greater profits to receive 
still greater profits. Borrowing, already stimulated, is stim- 
ulated still further. More loans are demanded, and, with 
the resulting expansion of bank loans, deposit currency 



Sec. 3] TRANSITION PERIODS 187 

(M'), already expanded, expands still more. Hence prices 
rise still further. 

This sequence of events may be briefly stated as 
follows : — 

(i) Prices rise (whatever the first cause may be ; we have 
chosen for illustration an increase in the amount of money 
in circulation). 

(2) " Enterprisers," i.e., persons who undertake business 
enterprises of various kinds, get much higher prices than 
before, without having much greater expenses, and therefore 
make much greater profits. 

(3) Enterpriser-borrowers, encouraged by large profits, 
expand their loans. 

(4) Deposit currency (M') expands relatively to money 

(5) Because of this expansion of deposit currency {M') 
prices continue to rise ; that is, phenomenon No. i is 
repeated. Then No. 2 is repeated, and so on. 

In other words, a slight initial rise of prices sets in motion 
a train of events which tends to repeat itself. Rise of prices 
generates rise of prices, and continues to do so as long as the 
enterprisers^ profits continue abnormally high. 

§ 3. How a Rise of Prices Culminates in a Crisis 

The expansion in deposit currency indicated in this cu- 
mulative movement abnormally increases the ratio of M' 
to M. This, however, is not the only disturbance caused 
by the increase in M. There are disturbances to some ex- 
tent in the Q's, in F, and in V' . In particular, trade (the 
<2's) will be stimulated by the stimulation of loans. New 
constructions of buildings, etc., are entered upon. These 
effects are always observed during rising prices, and people 
note approvingly that " business is good " and " times are 
booming." Such statements represent the point of view 
of the ordinary business man who is an " enterpriser- 



l88 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. X 

borrower." They do not represent the sentiments of the 
creditor, the salaried man, or the laborer, most of whom 
are silent but long-suffering, paying higher prices, but not 
getting proportionally higher incomes. 

But the expansion cannot proceed forever. It must 
ultimately spend itself. A check upon its continued opera- 
tion lies in making loans harder to get. As soon as this 
occurs, the whole situation is changed. The banks are 
forced in self-defense to refuse loans (or at any rate to dis- 
courage loans by making harder terms for them) because 
they cannot stand so abnormal an expansion of loans rela- 
tively to reserves. Then borrowers can no longer hope 
to make great profits, and loans cease to expand. 

There are other forces placing a limitation on further ex- 
pansion of deposit currency and introducing a tendency to con- 
traction, but those above mentioned are the most important. 

Now an enterprise, as it is started by borrowing, is ex- 
pected to be continued by renewed borrowing. But with 
loans hard to get, those persons who have counted on re- 
newing their loans on the former terms and for the former 
amounts are unable to do so. It follows that those of them 
who cannot contract new debts and, without contracting 
such new debts, cannot pay old ones are destined to be- 
come insolvent and fail. The failure (or prospect of failure) 
of firms that have borrowed heavily from banks induces fear 
on the part of many depositors that the banks will not be 
able to realize on these loans. Hence the banks themselves 
fall under suspicion, and for this reason depositors demand 
cash. Then occur " runs on the banks," which deplete the 
bank reserves at the very moment they are most needed to 
pay the demands of the depositors. Being short of reserves, 
the banks have to curtail their loans. Renewed borrowing 
becomes difficult or impossible, and even the original loans 
may be " called " by the banks. Those enterprisers who 
are caught must have currency to liquidate their obligations 
or else become insolvent. Some of them are destined to 



Sec. 4] TRANSITION PERIODS 1 89 

become bankrupt, and, with their failure, the demand for 
loans is correspondingly reduced. This culmination of an 
upward price rhovement is what is called a crisis, a condi- 
tion characterized by failures which are due to a lack of 
cash when it is most needed. Bankruptcies, as shown in 
Chapter III, § 5, tend to spread from debtor to creditor. 

§ 4. Completion of the Credit Cycle 

After the crest of the wave is reached, a reaction sets in. 
Bank loans tend to be small, and consequently deposits 
{M') are reduced. The contraction of deposit currency 
makes prices fall still more. Those who have borrowed 
for the purpose of buying stocks of goods, now find they 
cannot sell them for enough even to pay back what they 
have borrowed. The sequence of events is now the oppo- 
site of what it was before : — 

(i) Prices fall. 

(2) Enterprisers get much lower prices than before with- 
out having much lower expenses, and therefore make much 
lower profits. 

(3) Enterpriser-borrowers, discouraged by small profits, 
contract their borrowings. 

(4) Deposit currency (if') contracts relatively to money 
(M). 

(5) Because of this contraction of deposit currency 
{M') prices continue to fall ; that is, phenomenon No. i is 
repeated. Then No. 2 is repeated, and so on. 

Thus a fall of prices generates a further fall of prices. 
The cycle evidently repeats itself as long as the enterprisers' 
profits remain abnormally low. The man who loses most 
is the business man in debt. He is the typical business man, 
and he now complains that " business is bad." There is a 
" depression of trade." 

The contraction becomes self-limiting as soon as loans are 
easier to get. Banks are led to make loans easy in order to 



igo ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. X 

get rid of their accumulated reserves. After a time, normal 
conditions begin to return. The weakest producers have 
been forced out, or have at least been prevented from ex- 
panding their business by increased loans. The strongest 
firms are left to build up a new credit structure. Borrowers 
again become willing to take ventures ; failures decrease in 
number ; bank loans cease to decrease ; prices cease to fall ; 
borrowing and carrying on business becomes profitable ; loans 
are again demanded ; prices again begin to rise, and there 
occurs a repetition of the upward movement already described. 

The upward and downward movements taken together 
constitute a complete credit cycle, which resembles the for- 
ward and backward movements of a pendulum. 

Many historical examples could be cited. The discovery 
of gold in Cahfornia in the middle of the last century was 
followed by an inflation of the world's currency, first through 
the new gold and later through expansion of deposit currency 
as well. Prices rose rapidly ; business men made high prof- 
its ; times were good until 1857, when a crisis occurred both 
in the United States and Europe. This was followed by 
a sharp fall in prices, a depression in trade, a recovery and 
another period of inflation culminating in a second crisis in 
1866. Again the pendulum swung back, only to return 
again in the crisis of 1873. A more recent example is found 
in the gold inflation beginning in 1896 in consequence of the 
enormous gold production in the Transvaal, in Cripple Creek, 
and in the Klondike. The money in circulation in the 
United States doubled in eleven years (1896-1907), bank 
deposits subject to check nearly trebled, prices rose 50 per 
cent. "Prosperity" (that is, profitable business from the 
point of view of the enterpriser) seemed boundless. In 
1907 the wave broke in the crisis of that year, followed by 
a contraction of deposits and a fall of prices in the next year 
with a gradual recovery in the years immediately following. 

We have considered the rise, culmination, fall, and re- 
covery of prices. In most cases the time occupied by the 



Sec. 4] TRANSITION PERIODS I9I 

swing of the commercial pendulum to and fro is about ten 
years. While the pendulum is continually seeking a stable 
position, practically there is almost always some occurrence 
to prevent perfect equilibrium. Oscillations are set up which, 
though tending to be self-corrective, are continually per- 
petuated by fresh disturbances. 

The factors in the equation of exchange are continually 
seeking normal adjustment. A ship in a calm sea will 
" pitch " only a few times before coming to rest. But in a 
high sea the pitching never ceases. While continually 
seeking equiUbrium, the ship continually encounters causes 
which accentuate the oscillation. 

The foregoing sketch of prices gives, of course, only the 
elementary features of price cycles. In any actual case 
numerous special factors enter. The factors which we have 
studied are those in the equation of exchange. 



CHAPTER XI 

REMOTE INFLUENCES ON PRICES 

§ I. Influences which Conditions of Production and Con- 
sumption Exert on Trade and therefore on Prices 

Thus far we have considered the level of prices as affected 
by the volume of trade, by the velocity of circulation of 
money and of deposits, and by the quantity of money and 
of deposits. These are the only influences which can directly 
affect the level of prices. Any other influences on prices 
must act through these five. There are myriads of such 
influences (outside of the equation of exchange) that af- 
fect prices through the medium of these five. It is our 
purpose in this chapter to note the chief among them, 
excepting those that affect the volume of money {M) ; 
the latter will be examined in the next chapter. 

We shall first consider the outside influences that affect 
the volume of trade and, through it, the price level. The 
conditions which determine the extent of trade in the world 
or within any particular area are numerous and technical. 
The most important may be classified as follows : — 

1. Conditions affecting producers. 

(a) Geographical differences in natural resources. 

(b) The division of labor. 

(c) Knowledge of the technique of productior 

(d) The accumulation of capital. 

2. Conditions affecting consumers. 

(a) The extent and variety of human wants. 
192 



Sec. i] influences ON PRICES 1 93 

3. Conditions connecting producers and consumers. 

(a) Facilities for transportation. 

(b) Relative freedom of trade. 

(c) Character of monetary and banking systems. 

(d) Business confidence. 

I. (a) Geographical differences. If all localities were 
exactly alike in their natural resources, no trade would be 
set up between them. Cattle raising in Texas, the produc- 
tion of coal in Pennsylvania, of oranges in Florida, of 
apples in Oregon, etc., promote trade among these com- 
munities. 

I. (b) Divisioft of labor. By division of labor is meant 
the system by which different individuals in society per- 
form different kinds of work. It is based in part on dif- 
ferences in comparative costs or efforts of different men 
producing different goods — corresponding to geographic 
differences as between countries. Because of such differ- 
ences, natural and acquired, some men devote themselves 
to farming, others to weaving, others to carpentry, others 
to mason work, plumbing, typesetting, moving pianos, or 
driving aeroplanes, and exchange their products. 

I. (c) Knowledge of technique. Besides local and personal 
differentiation, the state of knowledge of the means and 
methods of production will stimulate trade. For instance, 
mines of Africa and Australia were left unworked for cen- 
turies by ignorant natives, but were opened by white men 
possessing a knowledge of metallurgy. 

I. (d) Accumulation of capital. But knowledge, to be 
of use, must be applied; and its application usually re- 
quires the aid of capital. The greater and the more pro- 
ductive the stock of capital in any community, the more 
goods it can put into the currents of trade. A mill will 
make a town a center of trade. Docks, elevators, ware- 
houses, and railway terminals help to transform a harbor 
into a port of commerce. 



194 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XI 

Since increase in trade tends to decrease the general level 
of prices, it is obvious that anything which tends to 
increase trade likewise tends to decrease the general level 
of prices. We conclude, therefore, that among the 
various causes which tend to decrease prices are greater 
geographical or personal specialization, improved produc- 
tive technique, and the accumulation of capital. 

2, (a) Extent and variety of human wants. Wants are, 
as it were, the mainsprings of economic activity which in 
the last analysis keep the economic world in motion. The 
desire to have clothes as fine as the clothes of others, or 
finer, or different, leads to the multiplicity of silks, satins, 
laces, etc. ; and the same principle applies to furniture, 
amusements, books, works of art, and every other means 
of gratification. 

The increase of wants, in so far as it leads to an increase 
in trade, tends to lower the price level. 

§ 2. Influences which Conditions Connecting Producers 
and Consumers Exert on Trade and therefore on 
Prices 

3. (a) Facilities for transportation. As Macaulay said, 
with the exception of the alphabet and the printing press, 
no set of inventions has tended to alter civilization so much 
as those which abridge distance — such as the railway, the 
steamship, the telephone, the telegraph, and that conveyer 
of information and advertisements, the newspaper. These 
all tend, therefore, to decrease prices. 

3. {h) Relative freedom of trade. Trade barriers are not 
only physical, but legal. A tariff between countries has 
the same influence in decreasing trade as a chain of moun- 
tains. The freer the trade, the more of it there will be. In 
France, many communities have a local tariff {octroi) which 
tends to interfere with local trade. In the United States, 
trade is free within the country itself, but between the 



Sec. 2] INFLUENCES ON PRICES 1 95 

United States and other countries there is a high protective 
tariff. The very fact of increasing faciHties for transporta- 
tion, lowering or removing physical barriers, has stimulated 
nations and communities to erect legal barriers in their 
place. Tariffs not only tend to decrease the frequency of 
exchanges, but to the extent that they prevent international 
or interlocal division of labor and make countries more 
alike as well as less productive, they also tend to decrease 
the amounts of goods which can be exchanged. The ulti- 
mate effect is thus to raise prices. This is the effect on 
the general level of prices. Besides this general effect are 
the particular effects on those articles on which duties are 
laid, but with these particular effects we have here nothing 
to do. 

Another sort of restriction on trade is the " restraint of 
trade " of monopolies or combinations. These, of course, 
like any other reduction in the amounts of goods sold, 
tend to raise the general level of prices. 

3. (c) Monetary and banking systems. The development 
of efficient monetary and banking systems tends, among 
other effects, to increase trade. There have been times in 
the history of the world when the money was in so uncer- 
tain a state that people hesitated to make many trade 
contracts because of the lack of knowledge of what would 
be required of them when the contract should be fulfilled. 
In the same way, when people cannot depend on the good 
faith or stability of banks, they will hesitate to use deposits 
and checks. 

3. (d) Business confidence. Confidence, not only in banks 
in pax-ticular, but in business dealings in general, is truly 
said to be " the soul of trade." In South America there 
are many places waiting to be developed simply because 
capitalists do not feel any security in contracts there. They 
are fearful that by hook or by crook the fruit of any invest- 
ments they may make will be taken from them. 

We see, then, that prices will tend to fall through an 



196 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XI 

increase in trade, which may in turn be brought about by 
improved transportation, by increased freedom of trade, 
by improved monetary and banking systems, and by busi- 
ness confidence. 

§ 3. Influence of Individual Habits on Velocities of 
Circulation, and therefore on Prices 

Having examined those causes outside the equation 
which affect the volume of trade, our next task is to consider 
those outside causes which affect the velocities of circulation 
of money and of deposits. For the most part, the causes 
affecting one of these velocities affect the other also. These 
causes may be classified as follows : — 

1. Habits of the individual 

(a) As to hoarding, 

(b) As to book credit and loans, 

(c) As to the use of checks. 

2. Systems of payments in the community 

(a) As to frequency of receipts and of disbursements, 

(b) As to regularity of receipts and of disbursements, 

(c) As to correspondence between receipts and dis- 
bursements. 

3. General causes. 

(a) Density of population, 

(b) Rapidity of transportation. 

I. (a) Hoarding. Taking these up in order, we may first 
consider what influence hoarding has on the velocity of cir- 
culation. Velocity of circulation of money is the same 
thing as its rate of turnover. It is found (Chapter VIII, 
§ 3) by dividing the total payments effected by money in 
a year by the average amount of money in circulation in 
that year. It is an average of the rates of turnover of the 
individuals which compose the society. This velocity of 
circulation or rapidity of turnover of money is the greater 



Sec. 3] INFLUENCES ON PRICES 1 97 

for each individual, the more he expends with a given aver- 
age amount of cash on hand, or the less average cash he 
keeps for a given yearly expenditure. One man keeps an 
average of $10 in his pocket and expends $500 a year; 
he, therefore, turns over the contents of his pocket fifty 
times a year. Another, while expending the same sum 
($500), keeps the more prudent average of $20; he, there- 
fore, turns over his stock of cash only twenty-five times a 
year. 

Some people are by habit always impecunious or short of 
ready money and tend to have a high rate of turnover; 
others carry a full purse and have a slow rate of turnover. 
When, as used to be the custom in France, people put money 
away in stockings and kept it there for months, the velocity 
o± circulation must have been extremely slow. The same 
principle applies to deposits. 

Hoarded money is sometimes said to be withdrawn 
from circulation, but this is only another way of saying that 
hoarding tends to decrease the velocity of circulation. The 
only real distinction between " hoarding " money in a 
stocking or safe and " carrying " money in a purse is one 
of degree. The money remains in the stocking or safe 
longer than in the purse. In either case it may be said 
to be in circulation, but when " hoarded " it circulates 
much more slowly. In the case of individual hoards, as 
of misers, it is convenient to consider them as in circula- 
tion. Only in the case of the larger government hoards is 
it worth while to consider them as excluded from " money 
in circulation." 

I. (b) Book credit and loans. The habit of " charging," 
i.e., using book credit, tends to increase the velocity of 
circulation of money, because the man who gets things 
"charged" does not need to keep on hand as much money 
as he would if he made all payments in cash. A man who 
daily pays cash needs to keep cash for daily contingencies. 
The system of cash payments, unlike the system of book 



198 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XI 

credit, requires that money shall be kept on hand in advance 
of purchases. Evidently, if money must be provided in 
advance, it must be provided in larger quantities than 
when merely required to liquidate past debts. In the 
system of cash payments a man must keep money idle in 
advance, lest he be caught in the embarrassing position of 
lacking it when he most needs it. With book credit he 
knows that even if he should be caught without a cent 
in his pocket, he can still get supplies on credit. These 
he can pay for when money comes to hand. As soon as 
this money is received there is a use awaiting it to pay 
debts accumulated. For instance, a laborer receiving and 
spending $7 a week, if he cannot " charge," must make his 
week's wages last through the week. If he spends $1 a 
day, his weekly cycle must show on hand on successive 
days at least $7, $6, $5, $4, $3, $2, and $1, at which time 
another $7 comes in. This makes the average balance $4. 
The rate of turnover (ratio of expenditure to cash carried) 
is $ 7 -T- 4 or about twice a week. But if he can charge every- 
thing, and then wait until pay day to meet the resulting 
obhgations, he need keep nothing through the week, paying 
out his $7 when it comes in. His weekly cycle need show 
no higher balances than $7, $0, $0, $0, $0, $0, $0, averaging 
only $1, and the turnover is $7 -7- 1 or seven times a week. 

Analogous to book credit is the use of loans of any kind. 
In a highly organized center of trade, like the New York 
stock or produce exchanges, credit is extended to an extreme 
degree in order to facilitate the transactions of a large 
volume of business without the necessity of keeping on 
hand a large cash balance of money or deposits subject 
to check. Credit is extended by loans, by allowing pur- 
chases on small payments called '' margins," and in other 
ways. All these extensions of loan credits tend to increase 
the velocity of circulation of money and deposits. 

Through book credit and loans, therefore, the average 
amount of money or bank deposits which each person must 



Sec. 4) INFLUENCES ON PRICES 1 99 

keep on hand to meet a given expenditure is made less. 
This means that the rate of turnover is increased; for if 
people spend the same amounts as before, but keep smaller 
amounts on hand, the quotient of the amount spent divided 
by the amount on hand must increase. 

1. (c) Use of checks. The habit of using checks rather 
than money will also affect the velocity of circulation of 
money, because a depositor's surplus money will immedi- 
ately be put in the bank in return for a right to draw by 
check. 

Banks thus offer an outlet for any surplus pocket money or 
surplus till money, and tend to prevent the existence of idle 
hoards. In like manner, surplus deposits may be converted 
into cash — that is, exchanged for cash — as desired. In 
short, those who make use both of cash and deposits have 
the opportunity, by adjusting the two, to prevent either 
from being idle. 

We see, then, that these three habits — the habit of 
being impecunious, the habit of charging, and the habit of 
using checks — all tend to raise the level of prices through 
their effects on the velocity of circulation of money, or of 
deposits. 

§ 4. Influence of Systems of Payments on Velocities 
of Circulation and therefore on Prices 

2. {a) Frequency of receipts and of disbursements. The 
more frequently money or checks are received and dis- 
bursed, the shorter is the average interval between the 
receipt and the expenditure of money or checks, and the 
more rapid is the velocity of circulation. 

This may best be seen from an example. A change from 
monthly to weekly wage payments tends to increase the 
velocity of circulation of money. If a laborer is paid 
weekly $7, and reduces this evenly each day, ending each 
week empty-handed, his average cash, as we have seen, 



200 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XI 

would be a little over half of $7, or about $4. This makes 
his turnover nearly twice a week. Under monthly pay- 
ments, the laborer who receives and spends an average 
of $1 a day will have to spread the $30, more or less evenly, 
over the following thirty days. If, at the next pay day, 
he comes out empty-handed, his average money during 
the month has been about $15. This makes his turnover 
about twice a month. Thus the rate of turnover is more 
rapid under weekly than under monthly payments provided, 
of course, the introduction of weekly payments does not 
disturb some other factor influencing velocity. If it leads 
to cash payments in place of book credit, the rate of turn- 
over may really decrease instead of increasing. 

2. (b) Regularity of receipts and of disbursements. When 
the workingman can be fairly certain of both his receipts 
and expenditures, he can, by close calculation, adjust them 
so precisely as safely to end each payment cycle with an 
empty pocket. This habit is extremely common among 
certain classes of city laborers. On the other hand, if 
the receipts and expenditures are irregular, either in 
amount or in time, prudence requires the worker to keep 
a larger sum on hand to insure against mishaps. Even 
when foreknown with certainty, irregular receipts require 
a larger average sum to be kept on hand. We may, there- 
fore, conclude that regularity, both of receipts and of pay- 
ments, tends to increase velocity of circulation. 

2. (c) Correspondence between receipts and disbursements. 
We next consider the synchronizing of receipts and dis- 
bursements, i.e., making the payments come at nearly the 
same times as the times when receipts are obtained. It 
is manifestly a great convenience to the spender of money, 
or of deposits, if dealers to whom he is in debt will allow 
him to postpone payment until he has received his money 
or his check. This arrangement obviates the necessity of 
keeping much money or deposits on hand, and therefore 
increases their velocity of circulation. Where payments, 



Sec. s influences ON PRICES 20I 

such as rent, interest, insurance, and taxes, occur at 
periods irrespective of the times of receipts of money, it 
is often necessary to accumulate money or deposits in 
advance, thus increasing the average on hand, withdrawing 
money from use for a time, and decreasing the velocity 
of circulation. 

We conclude, then, that synchronizing and regularity of 
payment, no less than frequency of payment, tend to in- 
crease prices by increasing velocity of circulation. 

§ 5. Influence of General Causes on Velocities of Circu- 
lation and therefore on Prices 

3. {a) Density of population. The more densely popu- 
lated a locality, the more rapid will be the velocity of cir- 
culation, because there will be readier access to people from 
whom money is received or to whom it is paid. In the 
country, although there are no statistics on this subject, 
the velocity of circulation must be much slower than in the 
city. A lady who has a city house and a country house 
states that in the country she keeps money in her purse 
for weeks, whereas in the city she keeps it but a few days. 
Pierre des Essars has worked out the velocity of circula- 
tion at banks in many European cities. Examination of 
his figures reveals the fact that, in almost all cases, the 
larger the town in which the bank is situated, the more 
active the deposits. The bank of Greece has a turnover 
whose rate of rapidity is only four times a year, while that 
of the bank of France is over one hundred times a year. 

3. {h) Rapidity of transportation. Again, the more ex- 
tensive and the speedier the transportation in general, the 
more rapid the circulation of money. Anything which 
makes it easier to pass money from one person to another 
will tend to increase the velocity of circulation. Railways 
have this effect. The telegraph has increased the velocity 
of circulation of deposits, since these can now be trans- 



202 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XI 

ferred thousands of miles in a few minutes. Mail and 
express, by facilitating the transmission of bank deposits 
and money, have likewise tended to increase their velocity 
of circulation. 

We conclude, then, that density of population and rapidity 
of communication tend to increase prices by increasing 
velocities of circulation. 

§ 6. Influences on the Volume of Deposit Currency 
and therefore on Prices 

We have to consider lastly the specific outside influences 
on the volume of deposits subject to check. 
These are chiefly : — 

(i) The system of banking and the habits of the people 
in utilizing that system. 
(2) The habit of charging. 

(i) Systems and habits of banking. It goes without say- 
ing that a banking system must be devised and developed 
before deposits can affect prices or even exist. The inven- 
tion of banking has undoubtedly led to a great increase in 
deposits and a consequent rise of prices. This has been 
true, in spite of the fact that, as pointed out in § i, the 
development of efficient monetary and banking systems 
tends to increase trade and to that extent to lower the price 
level. Here, as in many other instances, the effects of 
improving monetary and banking facilities are complex, 
affecting more than one factor in the equation of exchange. 
The price-raising effect is far more important than the 
price-depressing effect. In the future one of the chief 
causes tending to raise prices will doubtless be the expan- 
sion of deposits subject to check. 

(2) Habit of charging. We have already seen that 
" charging " increases the velocity of circulation of money. 
It is also a means of increasing the volume of deposits sub- 



Sec. 6] INFLUENCES ON PRICES 203 

ject to check ; that is, " charging " is often a preHminary 
to payment by check rather than by cash. If a customer 
did not have his obligations " charged," he would pay by 
money and not by check. The ultimate effect of the prac- 
tice of charging, therefore, is to increase the ratio of check 
payments to cash pa3Tiients and the ratio of deposits to 
money carried {M' to M) and therefore to increase the 
amount of credit currency which a given quantity of 
money can sustain. 

This effect, the substitution of checks for cash payments, 
is probably by far the most important effect of " charging," 
and exerts a powerful influence toward raising prices. 

Anything which tends to increase bank deposits tends, 
to that extent, to raise prices. Thus the creation of 
" trusts " has resulted in the issue of a great mass of stocks 
and bonds which are more readily accepted by bankers as 
" collateral " for loans than the stocks and bonds of the 
smaller and less known companies from which the " trusts " 
are formed. The consequence is : more bank loans, greater 
deposits, and a higher level of prices. Besides these and 
the other effects of " trusts," which have been mentioned 
elsewhere, on the general level of prices there are the more 
obvious and direct effects on the particular prices of the 
goods dealt in by the "' trusts." But we have here nothing 
to do with particular prices. We may observe, however, 
that when trusts raise particular prices it does not follow 
that they raise the general level of prices. Unless they 
disturb the five factors, M, M\ V, V\ or T, they cannot 
affect the general level of prices; for, in that case, the 
general level of prices, as the equation of exchange shows, 
could not be disturbed either, and the raising of prices of 
particular trust-made articles would have to result indi- 
rectly in lowering the prices of some other goods enough 
to compensate in the general level. 



CHAPTER XII 

REMOTE INFLUENCES 

(Continued) 

§ I. Influence of " The Balance of Trade " on the 
Quantity of Money and therefore on Prices 

We have now considered those influences outside the 
equation of exchange which affect the volume of trade (the 
Q'a), the velocities of circulation of money and deposits (F 
and V'), and the amount of deposits {M'). We have re- 
served for separate treatment in this chapter the outside 
influences which affect the quantity of money (M) . 

The chief of these may be classified as follows : — 

(i) Influences operating through the exportation and 
importation of money. 

(2) Influences operating through the melting or minting 
of money. 

(3) Influences operating through the production and 
consumption of money metals. 

(4) Influences of monetary and banking systems. 

The first to be considered is the influence of foreign 
trade on the quantity of money in a country and therefore 
on its price level. Hitherto we have confined our studies 
of price levels to an isolated community, having no trade 
relations with other communities. In the modern world, 
however, no such community exists, and it is important to 
observe that international trade gives present-day problems 
of money and of the price level an international character. 

204 



Sec. i] remote INPLUENCES 205 

If all countries had their own irredeemable paper money and 
no money that was acceptable elsewhere, price levels in 
different countries would have no intimate connection. 
Indeed, the connection is actually slight as between coun- 
tries which have different metallic standards, for exam- 
ple, between a gold-basis and a silver-basis country. But 
where two or more nations trading with each other use 
the same standard, there is a tendency for the price levels 
of each to influence profoundly the price levels of the other. 

The price level in a small country like Switzerland de- 
pends largely upon the price level in other countries ; for if 
the price level in these other countries is higher or lower 
than in Switzerland, the difference will set up trade currents 
which will increase or decrease the quantity of mone/ in 
Switzerland and therefore raise or lower its level of prices 
to correspond to the levels outside. Gold, which is the pri- 
mary or full-weight money in most civilized nations, is in 
this way constantly sent from one country or community to 
another. When a single small country is under considera- 
tion, while it is quite correct to say that the quantity of 
money in that country determines the price level, we must 
not fail to note that the quantity of money within its borders 
is in turn dependent upon the level of prices outside. An in- 
dividual country bears the same relation to the world that a 
lagoon bears to the ocean. The level of the lagoon depends, 
of course, upon the quantity of water in it. But the 
quantity of water in it depends in turn upon the level of the 
ocean. As the tide in the outside ocean rises and falls, the 
quantity of water in the lagoon will adjust itself accordingly. 

To simpHfy the problem of the distribution of money 
among different communities, we shall, for the time being, 
ignore the fact that money consists ordinarily of material 
capable of nonmonetary uses. We shall therefore omit 
consideration of the disappearance of money through 
melting ; likewise, for the present, we shall omit considera- 
tion of the production of money through minting. 



206 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap, XII 

Let US, then, consider the causes that determine the 
quantity of money in a state Hke Connecticut. If the level 
of prices in Connecticut temporarily falls below that of 
the surrounding states, Rhode Island, Massachusetts, 
and New York, the effect is to cause an export of money 
from these states to Connecticut, because people will buy 
goods wherever they are cheapest and sell them wherever 
they are dearest. With its low prices, Connecticut becomes 
a good place to buy from, and a poor place to sell in. But 
if outsiders buy of Connecticut, they will have to bring 
money to buy with. There will, therefore, be a tendency 
for money to flow to Connecticut until the level of prices 
there rises to a level which will arrest the influx. If, on 
the other hand, prices in Connecticut are higher than in 
surrounding states, it becomes a good place to sell in and a 
poor one to buy from. But if outsiders sell in Connecticut, 
they will receive money in exchange. There is then a tend- 
ency for money to flow out of Connecticut until the level 
of prices in Connecticut is lower. In general, money flows 
away from places where the level of prices is high, and to- 
wards places where it is low. Men sell goods where they 
can get most money, and buy goods where they will have 
to give least money. We say " money," for in the long 
run we do not need to consider the interflow of bank de- 
posits; as we have seen, in the long run deposit currency 
in each country will maintain a definite ratio to money. 
In the long run an increase or decrease of money in a 
country will increase or decrease its deposits. 

But it must not be inferred that the prices of various 
articles or even the general level of prices will become 
precisely the same in different countries. Distance, igno- 
rance as to where the best markets are to be found, 
tariffs, and costs of transportation, help to maintain 
price differences. The native products of each region 
tend to be cheaper in that region. They are exported as 
long as the excess of prices abroad is enough to more than 



Sec. i] remote influences 207 

cover the cost of transportation. Ordinarily a commodity 
will not he exported at a price which will not at least he equal 
to the price in the country of origin, plus the freight. Many 
commodities are shipped only one way. Thus, wheat is 
shipped from the United States to England, but not from 
England to the United States. It tends to be cheaper in 
the United States. Large exportations raise its price in 
America toward the price in England, but the American 
price will usually remain below the English price by the 
cost of transportation. A few commodities may be sent 
in either direction, according to market conditions. 

But, although international or interlocal trade will never 
bring about exact uniformity of price levels, it will, to the 
extent that it exists, produce an adjustment of these levels 
toward uniformity by regulating, in the manner already 
described, the distribution of money. If one commodity 
enters to any considerable extent into international trade, 
it alone will suffice, though slowly, to act as a regulator 
of money distribution; for, in return for that commodity, 
money may flow, and, as the price level rises or falls, the 
quantity of that commodity sold is correspondingly adjusted. 
In ordinary intercourse between nations, even when a de- 
liberate attempt is made to interfere with it by protective 
tariffs, there will always be a large number of commodities 
thus acting as outlets and inlets. And since the quantity 
of money itself affects prices for all sorts of commodities, 
the regulative effect of international trade applies, not 
simply to the commodities which enter into that trade, 
but to all others as well. It follows that nowadays interna- 
tional or interlocal trade is constantly regulating price 
levels throughout the world. 

We must not leave this subject without emphasizing 
the effects of a tariff on the purchasing power of money. 
When a country adopts a duty on imports, the tendency is 
for the level of prices in that country to rise. A tariff 
obviously raises the prices of the " protected " goods. Thus 



2o8 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XII 

the high duties on wool and woolen goods have kept Amer- 
ican prices of wool and woolens higher than European 
prices. But the tariff does more than that — it tends also 
to raise the prices of wwprotected goods. Thus, the tariff 
first causes a decrease in imports. This sudden decrease in 
imports will lead to a corresponding but gradual decrease 
in exports. This gradual check on exports will come about 
indirectly. The foreigner will, for a time, continue to 
buy from the protected country almost as much as before. 
This unchecked buying of goods means unchecked export 
of goods while the imports have suddenly been checked. 
There will result, therefore, a temporary excess of the pro- 
tected country's exports over its imports, or a so-called 
" favorable " balance of trade, that is, a net inflow of 
money. This inflow will eventually raise the prices, not 
alone of protected goods, but of unprotected goods as well. 
The rise will continue till it reaches a point high enough to 
put a stop to the " favorable " balance of trade, — that 
is, until foreigners cease to send in their money. 

Although the " favorable balance " of trade created by 
a tariff is temporary, it leaves behind a permanent in- 
crease of money and of prices. This is, perhaps, the chief 
reason why a protective tariff seems to many a cause of 
prosperity. It furnishes a temporary stimulus not only to 
protected industries, but to trade in general, which is in 
reality simply the stimulus of money inflation. The per- 
manent effect is to keep prices in general, including wages, 
at a higher level in the protected country than in free trade 
countries. This is doubtless one reason why American 
wages and prices are higher than English. 

We have shown how the international or interlocal 
equilibrium of prices may be disturbed by changes in the 
distribution of money alone. But it may also be disturbed 
by changes in the volume of bank deposits, or in the velocity 
of circulation of money, or in the velocity of circulation 
of bank deposits, or in the volume of trade. But whatever 



Sec. 2] REMOTE INFLUENCES 209 

may be the source of the difference in price levels, equi- 
librium will eventually be restored through an international 
or interlocal redistribution of money and goods brought 
about by international or interlocal trade. Elements in 
the equation of exchange other than money and com- 
modities cannot be transported from one place to another. 

§ 2. Influence of Melting and Minting on the Quantity 
of Money and therefore on Prices 

We have seen how M in the equation of exchange is 
affected by the importation or exportation of money. 
Considered with reference to the M in any one of the 
countries concerned, the M 's in all the others are " outside 
influences." 

Proceeding now one step farther, we must consider those 
influences on M that are not only outside of the equation 
of exchange for any particular country, but also outside 
that for the whole world. Besides the monetary inflow and 
outflow through importation and exportation, there is an 
inflow and outflow through minting and melting. In other 
words, not only do the stocks of money in the world connect 
with each other like interconnecting bodies of water, but they 
connect in the same way with the outside stock of bullion. 
In the modern world one of the precious metals, such as 
gold, usually plays the part of primary money, and this 
metal has two uses — a monetary use and a commodity use. 
That is to say, gold is not only a money material, but a 
commodity as well. In their character of commodities, the 
precious metals are raw materials for jewelry, works of 
art, and other products into which they may be wrought. 
It is in this unmanufactured or raw state that they are 
called bullion. 

Gold money may be changed into gold bulHon, and 
vice versa. In fact, both changes are going on constantly, 
for if the value of gold as compared with other commodities is 



2IO ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XII 

greater in the one use than in the other, gold will immediately 
flow toward whichever use is more profitable, and the market 
price of gold bullion in terms of gold money will determine 
the direction of the flow. Since loo ounces of gold, jq fine, 
can be transformed into i860 gold dollars, the market value 
of so much gold bullion, 1% fine, must tend to be $1860. If 
it costs nothing to have bullion coined into money, and 
nothing to melt money into bullion, there will be an 
automatic flux and reflux from money to bullion and 
from bullion to money that will prevent the price of 
bullion from varying greatly. On the one hand, if the 
price of gold bullion is greater than the money which 
could be minted from it, for instance, if 100 ounces of gold 
sell for $1861, the users of gold who require bullion — 
notably jewelers — will save the $1 difference by melting 
$ i860 of gold coin into 100 ounces of bullion. Contrariwise, 
if the price of bullion is less than the value of gold coin, 
say $1859, the owners of' bullion will save the $1 difference 
by taking 100 ounces of bullion to the mint and having it 
coined into i860 gold dollars. The effect of melting coin, 
on the one hand, is to decrease the amount of gold money 
and increase the amount of gold bullion, thereby lowering 
the value of gold as bullion and raising the value of gold 
as money ; and thereby also lowering the price level and 
restoring the equality between bullion and money. The 
effect of minting bullion into coin is, by the opposite pro- 
cess, to bring the value of gold as coin and the value of 
gold as bullion into equilibrium. 

When a charge called " seigniorage " is made for changing 
bullion into coin, or where the process involves expense or 
delay, the flow of bullion into currency will be to that extent 
impeded. But under a modern system of free coinage and 
with modern methods of reducing coin to bullion, both 
melting and minting may be performed so inexpensively 
and so quickly that there is practically no cost or delay 
involved. In fact, there are few instances of more exact 



Sec. 3] REMOTE INFLUENCES 211 

price adjustment than the adjustment between gold bullion 
and gold coin. It follows that the quantity of money, and 
therefore its purchasing power, is directly dependent on 
that of gold bullion. 

This stabiHty of the price of gold bullion expressed in 
gold coin causes confusion in the minds of people, giving 
them the erroneous impression that there is no change 
in the value of money. Indeed, this stability has often 
been cited to show that gold is a stable standard of value. 
Dealers in objects made of gold seem to misunderstand 
the significance of the fact that an ounce of gold (tV fine) 
always costs $18.60 in the United States or {\l fine) £3, 
17.?., lo^d. in England. This means nothing more than 
the fact that gold in one form and measured in one way 
will always bear a constant ratio to gold in another form 
and measured in another way. An ounce of gold bullion 
is worth a fixed number of gold dollars, for the same reason 
that a pound sterling of gold is worth a fixed number of 
gold dollars, or that a ton of large steel ingots is worth a 
fixed number of pounds of small steel ingots. 

Except, then, for extremely slight and temporary fluctu- 
ations, gold bullion and gold money must always have the 
same value. Therefore, in the following discussion re- 
specting the more considerable fluctuations affecting both, 
we shall speak of these values interchangeably as "the 
value of gold." 

§ 3. Influence of the Production and Consumption of 
Money Metals on the Quantity of Money and there- 
fore on Prices 

The stock of bullion is not the ultimate outside influence 
on the quantity of money. As the stock of bullion and the 
stock of money influence each other, so the total stock of 
both is itself influenced by production and consumption. 
The production of gold consists in the output of the mines, 



212 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

which constantly tends to add to the existing stocks both 
of bullion and coin. The consumption of gold consists 
in the use of bullion in the arts by being wrought into 
jewelry, gilding, etc., and in losses of coin by abrasion, ship- 
wreck, etc. If we consider the amount of gold coin and 
bullion as a sort of reservoir, production would be the in- 
flow from the mines, and consumption the outflow to the 
arts and by destruction and loss. To the inflow from the 
mines should be added the re-inflow from forms of art into 
which gold had previously been wrought, but which have 
since become obsolete. This is illustrated by the business 
of producing gold bullion by burning gold picture frames. 

We shall consider, first, the inflow or production, and 
afterward the outflow or consumption. The regulator 
of the inflow (which practically means the production of 
gold from the mines) is its estimated cost of production. 
Wherever the estimated cost of producing a dollar of gold 
is less than the existing value of a dollar in gold, the gold 
will (normally) be produced. Wherever the cost of pro- 
duction exceeds the existing value of a dollar, the gold 
will (normally) not be produced. In the former case the 
production of gold is profitable ; in the latter it is unprofit- 
able. 

This holds true, in whatever way cost of production is 
measured, whether in terms of gold itself, or in terms of 
some other commodity such as wheat, or of commodities 
in general. In gold-standard countries the gold miner does 
actually reckon the cost of producing gold in terms of gold. 
From his standpoint it is a needless complication to trans- 
late the cost of production and the value of the product 
into some other standard than gold. He is interested in 
the relation between the two, and this relation will be the 
same whichever standard is employed. To illustrate how 
the producer of gold measures everything in terms of gold, 
suppose that the price level rises. He will then have to 
pay more dollars for wages, machinery, fuel, etc., while the 



Sec. 3] REMOTE INFLUENCES 213 

prices obtained for his product (expressed in those same 
dollars) will, as always, remain unchanged. Conversely, 
a fall in the price level will lower his cost of production 
(measured in dollars), while the price of his product will 
still, as always, remain the same. Thus we have a vari- 
able number expressing the cost of production and a constant 
number expressing the price of gold product. 

If we express the same phenomena, not in terms of gold, 
but in terms of wheat, or rather, let us say, in terms of goods 
in general, we shall have the opposite conditions. Then 
a fall in the price level cannot be said to affect his cost of 
production (measured in goods), while the "price," or 
purchasing power, of his product over goods will rise. A 
constant number expresses the cost of gold and a variable 
number, its price (purchasing power). 

Thus the comparison between price and cost of production 
is the same, whether we use gold or other commodities as our 
criterion. In the one view — i.e., when prices of labor and 
commodities are measured in gold — a rise of these prices 
appears as a rise in the gold miner's cost of production — 
the money cost to him of labor and materials — while the 
price of his product, gold, appears constant ; in the other 
view — i.e., when labor and commodities are measured in 
other goods — the same phenomenon is expressed as a fall 
in the purchasing power of his product, gold, while the cost 
of labor and materials in terms of themselves is the constant 
quantity. In the one view his costs rise relatively to his prod- 
uct; in the other his product falls relatively to his costs. 
In either view he will be discouraged. He will look at his 
troubles in the former light, i.e., as a rise in the cost of 
production ; but we shall find it more useful to look at them 
in the latter, i.e., as a fall in the purchasing power of the 
product. In either case the comparison is between the cost 
of the production of gold and the purchasing power of 
gold. If this purchasing power is above the cost of pro- 
duction in any particular mine, it will pay to work that 



214 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XII 

mine. If the purchasing power of gold is lower than the 
cost of production in any particular mine, it will not pay- 
to work that mine. 

So much for the inflow of gold and the conditions regulat- 
ing it. We turn next to outflow or consumption of gold. 
This has two forms, viz., consumption in the arts and con- 
sumption for monetary purposes. 

First we consider its consumption in the arts. If objects 
made of gold are cheap — that is, if the prices of other 
objects are relatively high — then the relative cheapness 
of the gold objects will lead to an increase in their use 
and consumption. Expressing the matter in terms of money 
prices, when prices of everything else are higher and people's 
incomes are likewise higher, while gold leaf and gold orna- 
ments remain at their old prices, people will use and con- 
sume more gold leaf and ornaments. 

These are instances of the consumption of gold in the 
form of commodities. The consumption and loss of gold 
as coin is a matter of " abrasion " (gradual waste by wear- 
ing or rubbing against other coins or the hands, pocket, 
or purse), of loss by shipwreck and other accidents. They 
change with the changes in the amount of gold in use and 
in its rapidity of exchange. 

A fall, therefore, in the purchasing power or value of 
gold, affects both consumption and production. It stimu- 
lates consumption (that is, the turning of bullion into 
articles of commerce) ; and it discourages production. 
An increase of purchasing power, of course, acts in the 
opposite way. Conversely, consumption and production 
affect purchasing power. Consumption, or the with- 
drawal of bullion into commerce, raises the purchasing 
power of what is left, while production from the mines 
lowers the purchasing power. 

The purchasing power of money, being thus played upon 
by the opposing forces of production and consumption, is 
driven up or down as the case may be. 



Sec. 4] 



REMOTE INELUENCES 



215 



§ 4. Mechanical Illustration of these Influences 

In any complete picture of the forces determining the 
purchasing power of money we need to keep prominently 
in view three groups of factors : (i) the production or the 
" inflow" of gold {i.e., from the mines) ; (2) the consumption 
or " outflow " (into the arts and through destruction and 
loss) ; and (3) the " stock " or reservoir of gold (whether 




Fig. 13. 



coin or bullion) which receives the inflow and suffers the 
outflow. The relations among these three sets of magni- 
tudes can be set forth by means of a mechanical illustration, 
as shown in Figure 13. This represents two connected res- 
ervoirs of Hquid, Gj and G^- The contents of the first 
reservoir represent the stock of gold bullion, and the con- 
tents of the second the stock of gold money. Since pur- 
chasing power increases with scarcity, the distance from 
the top of the cisterns, 00, to the surface of the liquid 
(which evidently increases as the liquid grows more scarce) 
is taken to represent the purchasing power of gold over 
other goods. A lowering of the level of the liquid indicates 
the corresponding increase in the purchasing power of 



2l6 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

money, since we measure this purchasing power downward 
from the line 00 to the surface of the liquid. We shall not 
attempt to represent other forms of currency explicitly in 
the diagram. We have seen that normally the quantities of 
other currency are proportional to the quantity of primary 
money, which we are supposing to be gold. Therefore the 
variation in the purchasing power of this primary money 
may be taken as representative of the variation of all the 
currency. The cistern G^ must be of such a form as 
will make the distance of the liquid surface below 00 de- 
crease with an increase of the liquid, in exactly the same way 
as the purchasing power of gold decreases with an increase in 
its quantity. That is, as the quantity of liquid in G^ 
doubles, the distance of the surface from the line 00 should 
decrease by one half. In a similar manner the form of 
the gold bullion cistern must be such as will make it rep- 
resent faithfully the .facts for which it stands; that is, it 
must be such that the distance of the liquid surface below 
00 will decrease with an increase of the liquid exactly as 
the value of the gold bullion decreases with an increase in 
the stock of gold bullion. The shapes of the two cisterns 
need not, and ordinarily will not, be the same^ for we can 
scarcely suppose that doubling the amount of bulUon in 
existence will always exactly halve its purchasing power. 

Both reservoirs have inlets and outlets. Let us con- 
sider those belonging to the bullion reservoir {G^. Here 
each inlet represents a particular mine, supplying bullion, 
and each outlet represents a particular use in the arts, con- 
suming gold bullion. Each mine and each use has its own 
distance from 00. There are, therefore, three sets of dis- 
tances from 00 : the inlet-distances, the outlet-distances, 
and the liquid-surface-distances. Each inlet-distance rep- 
resents the cost of production, measured in goods, for 
some particular mine ; each outlet-distance represents the 
value which gold has or would have in the particular use 
represented, likewise measured in goods. The surface- 



Sec. 4] REMOTE INFLUENCES 21 7 

distance, as we have already explained, represents the value 
of bullion, likewise measured in goods — in other words, 
its purchasing .power. 

It is evident that among these three sets of levels there 
will be discrepancies. These discrepancies serve to inter- 
pret the relative state of things as bullion flows in and out. 
If an inlet at a given moment be above the surface-level, i.e., 
at a less distance from 00 than is the surface, the interpre- 
tation is that the cost of production is less than the purchas- 
ing power of the bullion. Hence the mine owner will turn on 
his spigot and keep it on until, perchance, the surface-level 
rises to the level of his mine — i.e., until the surface-distance 
from 00 is as small as the inlet-distance — in other words, 
until the purchasing power of bullion is as small as the cost 
of production. At this point there is no longer any profit in 
mining. So much for inlets ; now let us consider the outlets. 
If an outlet at a given moment be below the surface-level, i.e., 
at a greater distance from 00, the interpretation is that the 
value of gold in that particular use is greater than the pur- 
chasing power of bullion. Hence gold bullion will flow into 
those uses where its value may happen for the moment to 
be greater than its value as bullion. That is, it will flow 
out of all outlets helow the surface in the reservoir. 

It is evident, therefore, that at any given moment, only 
the inlets above the surface-level, and only the outlets 
below it, will be called into operation. As the surface 
rises, therefore, more outlets will be brought into use, but 
fewer inlets. That is to say, the less the purchasing power 
of gold as bullion, the more it will be used in the arts, but 
the less profitable it will be for the mines to produce it, 
and the smaller will be the output of the mines. As the 
surface falls, more inlets will come into use and fewer out- 
lets. 

We turn now to the money reservoir {GJ). The fact 
that gold has the same value either as bullion or as coin, 
because of the interflow between them is represented in the 



2l8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

diagram by connecting the bullion and coin reservoirs, in 
consequence of which the stock in both will (like water) find 
a common level ; the surface of the liquid in both reservoirs 
will be the same distance below the line 00, and this distance 
represents the value of gold (or its purchasing power). 
Should the inflow at any time exceed the outflow, the result 
will necessarily be an increase in the stock of gold in exist- 
ence. This will tend to decrease the purchasing power or 
value of gold. But as soon as the surface rises, fewer inlets 
and more outlets will operate. That is, the excessive inflow 
on the one hand will decrease, and the deficient outflow 
or consumption on the other hand will increase, checking 
the inequality between the outflow and inflow. If, on the 
other hand, the outflow should temporarily be greater 
than the inflow, the reservoir will tend to become less full. 
The purchasing power will increase; thus the excessive 
outflow will be checked, and the deficient inflow stimulated 
— restoring equilibrium. The exact point of equilibrium 
may seldom or never be realized, but as in the case of a 
pendulum swinging back and forth about a position of 
equilibrium, there will always be a tendency to seek it. 

It need scarcely be said that our mechanical diagram 
is intended merely to give a picture of some of the 
chief variables involved in the problem under discussion. 
It does not of itself constitute an argument, or add any new 
element; nor should one pretend that it includes ex- 
plicitly all the factors which need to be considered. But it 
does enable us to grasp the chief factors involved in deter- 
mining the purchasing power of money. It enables us to 
observe and trace the following important variations and 
their effects : — 

First, if there be an increased production of gold — due, 
let us suppose, to the discovery of new mines or improved 
methods of working old ones — this may be represented 
by an increase in the number or size of the inlets into the 
bullion reservoir; the result will evidently be an increase 



Sec. 4] REMOTE INFLUENCES 219 

of " inflow " into that reservoir, and from that into the 
currency reservoir, a consequent gradual fiUing up of both, 
and therefore 4 decrease in the purchasing power of money. 
This process will be checked finally by an increase in con- 
sumption and by discouraging production. When pro- 
duction and consumption become equal, an equilibrium will 
be established. An exhaustion of gold mines obviously 
operates in exactly the reverse manner. 

Secondly, if there be an increase in the consumption 
of gold — as through some change of fashion — it may be 
represented by an increase in the number or size of the out- 
lets of Gf,. The result will be a draining out of the bullion 
reservoir, and consequently a decreased amount in the 
currency reservoir; hence an increase in the purchasing 
power of gold, which increase will be checked finally by an 
increase in the output of the mines as well as by a decrease 
in consumption. When the increased production and the 
decreased consumption become equal, equilibrium will 
again be reached. 

If the mints are closed, that is, if the connection be- 
tween the bullion reservoir and the currency reservoir is 
closed by a valve so that gold cannot flow from the for- 
mer to the latter (although it can flow in the reverse 
direction), then the purchasing power of the gold as money 
may become greater than its value as bullion. Any in- 
crease in the production of gold will then tend only to fill 
the bullion reservoir and decrease the distance of the sur- 
face from the line 00, i.e., lower the value of gold bullion. 
The surface of the liquid in the money reservoir will not be 
brought nearer 00. It may even by gradual loss be lowered 
farther away. In other words, the purchasing power of 
money will by such a circumstance be made entirely inde- 
pendent of the value of the bullion out of which it was first 
made. 

We have now discussed all but one of the outside influences 
upon the equation of exchange. That one is the character 



220 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XII 

of the monetary and banking system which affects the quan- 
tity of money and deposits. This we reserve for special 
discussion in the following chapter. 

Meanwhile, it is noteworthy that almost all of the 
influences which at the present time actually affect either 
the quantity or the velocities of circulation have been 
and are predominantly in the direction of higher prices. 
Almost the only opposing influence is the increased volume 
of trade. We may also point out that some of those 
influences discussed in this and the preceding chapter 
operate in more than one way. Consider, for instance, 
technical knowledge and invention, which affect the equa- 
tion of exchange by increasing trade. So far as these 
increase trade, the tendency is to decrease prices ; but so 
far as they develop metallurgy and the other arts which 
increase the production and transportation of the precious 
metals, they tend to increase prices. So far as they make 
the transportation and circulation of money and deposits 
quicker, they also tend to increase prices. So far as they 
lead to the development of the art of banking, they like- 
wise tend to increase prices both by increasing deposit 
currency {M') and by increasing the velocity of circula- 
tion both of money and deposits. So far as they lead 
to the concentration of population in cities, they tend 
to increase prices by accelerating circulation. 



CHAPTER XIII 

OPERATION OF MONETARY SYSTEMS 

§ I. Gresham's Law 

Thus far we have considered the influences that determine 
the purchasing power of money when the money in cir- 
culation is all of one kind. The illustration given in the 
previous chapter shows how the money mechanism operates 
when a single metal is used. We have now to consider the 
monetary systems in which two or more kinds of money 
are used. 

One of the first difficulties in the early history of money 
was that of keeping two or more metals in circulation at 
the same time. The monetary unit in one of the two would 
become cheaper than in the other, and the cheaper would 
drive out the dearer. 

To this tendency has been given the name of " Gresham's 
Law " in honor (rather undeservedly) of Sir Thomas 
Gresham, a financial adviser of Queen Elizabeth of Eng- 
land. He called attention to the tendency in the middle 
of the sixteenth century, although it is now known that 
many others had anticipated him. In fact, the law seems 
to have been recognized among the ancient Greeks. It is 
mentioned in the " Frogs " of Aristophanes : — 

" For your old and standard pieces, valued and approved and tried, 
Here among the Grecian nations and in all the world beside 
Recognized in every realm for trusty stamp and pure assay, 
Are rejected and abandoned for the trash of yesterday ; 
Por a vile, adulterate issue, drossy, counterfeit and base 
Which the trafi&c of the City passes current in their place ! " 



222 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

Gresham's Law is ordinarily stated in the form, " Bad 
money drives out good money," for it was usually ob- 
served that the badly worn, defaced, light-weight, " clipped," 
" sweated," and otherwise deteriorated money tended to 
drive out the full-weight, freshly minted coins. This for- 
mulation, however, is not accurate. " Bad " coins, e.g., 
worn, bent, defaced, or even clipped coins, will drive out 
other money only so far as they are less valuable. Some- 
times bright, freshly minted coins drive out old, dull de- 
faced coins, as, for instance, when new gold drove out 
silver from the United States shortly after 1837, the new 
gold dollars being cheaper than the old silver dollars. Ac- 
curately stated, the Law is simply this : The cheaper dollar 
(or whatever the monetary unit) tends to drive out the dearer. 
The reason why the cheaper of two moneys always prevails 
is that the choice of the use of money rests chiefly with 
the man who gives it in exchange, not with the man who 
receives it. When any one has the choice of paying his 
debts in either of two moneys, motives of economy will 
evidently prompt him to use the cheaper. If the initiative 
and choice lay principally with the person who receives 
instead of the person who pays the money, the opposite 
would hold true. The dearer or " good " money would 
then drive out the cheaper or " bad " money. It is 
because the payer of money exercises the choice that the 
cheaper money tends to be passed on and the dearer 
money to be withdrawn. Any individual into whose 
hands the two moneys may chance to fall may exercise 
this choice and withdraw the newly minted coins. But 
there are two classes especially interested and most instru- 
mental in withdrawing the " good " money from circula- 
tion ; namely, those who wish it either for export or for 
melting, — the bankers and the goldsmiths. 

What then becomes of the dearer money? It may be 
hoarded, or go into the melting pot, or go abroad — hoarded 
and melted from motives of economy, and sent abroad be- 



Sec. 2] OPERATION OF MONETARY SYSTEMS 223 

cause, where foreign trade is involved, it is the foreigner 
receiving the money, rather than ourselves giving it, 
who dictates what kind of money shall be accepted. He 
will take only the best, because our legal-tender laws do 
not bind him. 

Until " milling " the edges of coins (making the edges 
finely corrugated so that they cannot be filed or otherwise 
rubbed off without detecting) was invented, and a " limit 
of tolerance " of the mint (the deviation from the stand- 
ard weight beyond which the coin is rendered unacceptable 
in law as legal tender) was adopted, much embarrass- 
ment was felt in commerce from the fact that the clipping 
and debasing of coin was a common practice. Nowadays, 
however, any coin which has been so " sweated " or 
clipped as to reduce its weight appreciably ceases to be 
legal tender, and, being commonly rejected by those to 
whom it is offered, ceases to be money. Within the cus- 
tomary or legal limits of tolerance, however, — that is, as 
long as the cheaper money continues to be money, — it 
will tend to drive out the dearer. 

Gresham's Law applies not only to two rival moneys of 
the same metal ; it applies to all moneys that circulate con- 
currently. 

§ 2. Bimetallism 

The obvious effect of Gresham's Law is to decrease the 
purchasing power of money at every opportunity. The 
history of the world's currencies is largely a record of money 
debasements, often at the behest of the sovereign. Our 
chief purpose now, in considering Gresham's Law, is to for- 
mulate more fully the causes determining the purchasing 
power of money under monetary systems subject to the 
operation of Gresham's Law. The first application is to 
" bimetallism." Under bimetallism, governments open their 
mints to the free coinage of two metals (usually gold and 



224 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

silver) at a fixed coinage ratio, and make both sorts of 
coin unlimited legal tender at that ratio. ^ Under this sys- 
tem, the debtor has the -option, unless otherwise bound by- 
contract, of making payment either in gold or in silver 
money. These, in fact, are the two requisites of complete 
bimetallism, viz. : (i) the free and unlimited coinage of 
both metals at a fixed ratio, and (2) the unlimited legal 
tender of each metal at that ratio. 

The object of bimetallism is to render the purchasing 
power of money more stable ; but in order to understand 
fully the influence of any monetary system on the purchas- 
ing power of money, we must first understand its mechan- 
ism and mode of operation. It has been denied that 
bimetallism ever did or can work successfully so that gold 
and silver dolUrs circulate side by side at equal values. 
This denial is based on Gresham's Law by which the 
cheaper metal will drive out the dearer. Our first task 
is to show, quite irrespective of its desirability, that bi- 
metallism can and does " work " under certain circum- 
stances, but not under others. To make clear when it will 
work and when it will not, we shall state the effects of 
a bimetallic law first in words and then, for the sake of 
greater clearness and exactness, in terms of a mechanical 
illustration. 

Suppose that, at first, gold alone is freely coined (and is 
unlimited legal tender) and that then (as proposed in the 
United States by the " free silver " party in 1896 and 
1900) silver is put on exactly the sam.e basis, the mints 
being opened to its free coinage also. 

The results of thus opening the mints to silver at a ratio 
of 16 to I with gold will be different, according to the rela- 
tive market value of gold and silver before the mints are 

^ By the " coinage ratio " is meant the ratio of the weight of the silver 
dollar to that of the gold dollar. This is at present i6 to i ; for a silver 
dollar weighs 412^ grains, which is almost exactly sixteen times the weight 
of a gold dollar, 25.8 grains. 



Sec. 2] OPERATION OF MONETARY SYSTEMS 225 

opened. If 4122 grains of silver were dearer than 25.8 
grains of gold, there would be no silver coined at all, for 
no one will take 41 2^^ grains of silver to be coined and used 
as a dollar of money when he can get more than a gold 
dollar for it by selKng it as silver bullion. 

But if (as happens to be the case to-day) 412!^ grains of 
silver are cheaper than 25.8 grains of gold, every owner of 
silver buUion will make a profit by taking it to the mint. 
In this way he can get a silver dollar for every 412^ grains 
of silver bullion, while in the silver bullion market he can 
get only, let us say, fifty, cents. The result will be a wild 
scramble among all owners of silver bullion to get it coined, 
in order to transform each 4i2;| grains of it into a full- 
fledged dollar instead of the fifty cents which previously 
was all they could get for it. It is true that the new 
silver dollar may not be worth as much in purchasing 
power as a gold dollar; but, being legal tender, it will 
have just as great debt-paying power. 

There can be no doubt, then, that silver, being cheaper 
than gold, will be taken to the mint as soon as the bimetallic 
law takes effect. The question now is : What will be the 
result ? To this question the answer is briefly as follows : — 

I. The first effect (as has been emphasized by '' mono- 
metallists ") wUl be the operation of Gresham's Law, by 
which the cheap silver dollars will tend to expel the dear 
gold dollars from circulation. 

II. But (as emphasized by " bimetallists ") this very 
operation of Gresham's Law tends to reduce the disparity 
between the values of the gold and silver dollars. Owing 
to the eagerness of debtors to use silver instead of gold in 
paying their debts, the value of silver is increased and 
that of gold decreased. This mutual approach of the values 
of gold and silver dollars may result in making them equal. 

III. But (as pointed out by the '' monometallists ") the 
next result will be a great stimulus to the mining of silver 
and a great discouragement to the mining of gold. Con- 



226 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

sequently, silver will gradually become more plentiful, and 
therefore cheaper again, and gold scarcer, and therefore 
dearer again. Consequently, silver will again tend to 
expel gold. 

IV. But (as insisted by " bimetallists ") this increase 
of the stock of silver (coin and bullion) and decrease of 
the stock of gold are self-limiting ; for the increased 
production of silver wUl be checked by increased cost of 
production, and consumption will tend to overtake pro- 
duction, while the opposite adjustments apply to gold. 

We shall consider these results in their order. 

§ 3. When Bimetallism Fails 

I. In accordance with Gresham's Law, the cheap silver 
money will drive the dearer gold money out of circulation 
— either abroad or into the melting pot, or both. If there 
is a sufficient amount of silver bullion available, it will 
drive gold completely out of circulation, and the coun- 
try which enacted the law will find itself converted from 
a gold standard country into a silver standard country. 
There are many historical examples of such a breakdown 
of bimetallism, both in the United States and elsewhere. 

But even when bimetallism thus fails of its object (keep- 
ing both metals in circulation, with silver and gold dollars 
of equal value), it will, nevertheless, have had the effect of 
making them more nearly equal. A tendency toward equal- 
ization will have come about from two causes, one the 
fact that from the world's stock of silver bullion there 
has been taken away a great mass of silver {i.e., the silver 
turned into coin) , thus making the remaining silver bullion 
scarcer and dearer ; and the other the fact that to the world's 
stock of gold bullion there is suddenly added a great mass 
of gold {i.e., the gold melted from coin), thus making the 
gold bullion more abundant and cheaper in its purchasing 
power over other things. The result is that, though the 



Sec. 3] OPERATION OF MONETARY SYSTEMS 227 

law has failed to raise 41 2 1 grains of silver from the equiva- 
lent of half a dollar of gold to the equivalent of a whole 
dollar of gold, it may at any rate raise it a little. 

These effects can be more exactly shown by means of 
the mechanical illustration of the last chapter carried a little 
further. In this the amount of gold bullion is represented 
by the contents of reservoir Gj (Figs. 14, 15). Here, as 
before, we represent the purchasing power or value of 
gold by the distance of the liquid level below the zero level, 
00. In the last chapter, our figure represented only one 
metal, gold, and represented that metal in two reservoirs 
— the bullion reservoir and the coin reservoir. We shall 
now, one step at a time, elaborate that figure. First we 
add a reservoir for silver bullion {S^. This reservoir 
may be used to show the relation between the value or 
purchasing power of silver and its quantity considered as 
bullion. 

Here, then, are three reservoirs. At first (Fig. 14a) the 
silver reservoir is entirely isolated. For the present, let us 
suppose that the middle one, which contains money, is filled 
with gold money only (Figs. 14a, 15a), no silver being yet 
used as money. In other words, the monetary system is 
the same as that discussed in the last chapter. The only 
change here introduced is to add to the picture another 
reservoir {S^, entirely detached, showing the quantity and 
value of silver bullion. 

We next suppose a pipe opened at the right, connecting 
Sh with the money reservoir ; that is, we introduce bimetal- 
lism. These new conditions are represented in Figure 14&, 
where a pipe gives silver an entrance into the money or 
central reservoir. Thus the a part of the figure represents 
conditions before the mints are opened to silver. The h part 
represents conditions after they have been opened. 

The liquids representing gold and silver money are sepa- 
rated by a movable film/. In Figure 14a this film is at the 
extreme right ; in Figure 146, at the extreme left. 



228 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

We may disregard for the present all inlets and outlets ex- 
cept the connections between the bulKon reservoirs and the 
coin reservoir; because what we are about to represent is 
merely the relations between bullion (two kinds) and coins. 

Now in these reservoirs the surface-distances below 00 
represent, as has been said, the purchasing powers of gold 
and silver. A unit of liquid represents that quantity of 
gold or of silver which constitutes a unit of money. Of 




^.■=' — I -- .a> 



Fig. 14. 

course a silver dollar is physically larger than a gold dollar, 
but they are both represented in our diagram by the same 
unit, or drop, of liquid ; that is, each drop of liquid on the 
right side of the film / represents a dollar of silver (41 2 1 
grains), while each drop of liquid on the left of this film 
represents a dollar of gold (25.8 grains). 



Sec. 3] 



OPERATION or MONETARY SYSTEMS 



229 



In the figure the situation represented is such that the 
level of the silver bullion in the right reservoir is above the 
level of the other two reservoirs, which are filled with gold ; 
that is, the silver bullion is so abundant and cheap as to be 
ready to flow into the money reservoir as soon as the mint or 
connecting pipe is opened. Were this not the case (that is, 
if the silver level in the right reservoir were below the gold 
level in the other two reservoirs), it is evident that the 




Fig. 15. 



statute introducing bimetallism would be inoperative ; the 
silver bullion would not, as it were, flow uphill into the money 
reservoir. But if, as is represented in Figure 14a, the silver 
level is the higher, then, as soon as the mints are opened to 
silver (that is, as soon as the connecting pipe is inserted), 



230 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XIII 

silver will flow into circulation (into the money reservoir), 
and in accordance with Gresham's Law, will displace gold. 
It will continue to displace gold as long as it is cheaper than 
gold (that is, as long as the level of the inflowing silver 
liquid is above that of the gold liquid which it displaces). 
The gold money will be melted and turned into bullion 
(that is, pushed out through the left tube into the bullion 
market). 

It is evident that this operation of Gresham's Law may 
proceed so far that the money reservoir will be wholly 
cleared of gold and filled instead with silver, the film / having 
been swept completely to the left. This result is pictured 
in Figure 146, which illustrates the failure of bimetallism. 

§ 4. When Bimetallism Succeeds 

II. But such a result would not in all cases occur. It 
will occur only when, as is represented in Figure 14, there 
exists, to start with, a sufficiently great disparity between 
the silver and gold levels and a sufficiently large amount of 
silver bullion. 

These conditions need not always hold true. Let us sup- 
pose, for instance, that prior to the introduction of bimetal- 
lism 41 2§ grains of silver bullion, instead of being worth only 
fifty cents in terms of gold, should be worth ninety-five 
cents. Under these conditions the introduction of the free 
coinage of silver would mean introducing a new dollar 
worth, at the outset, at least ninety-five cents, or nearly par. 
It would still be true that the owner of silver bullion would 
be impelled to take it to the mint by the prospect of a profit 
of five cents on each 41 2^ grains, but it would not require 
much such coinage to raise the price of silver to par. The 
eagerness to get the new silver dollars would tend to raise 
their value, while the discarding of the old gold dollars 
would tend to lower their value. Just as soon as enough 
silver dollars had been coined out of silver bullion to bring 



Sec. 4] OPIJRATION OF MONETARY SYSTEMS 23 1 

them up to par in terms of gold, Gresham's Law would, of 
course, cease to operate, and we should have both silver 
and gold dollars circulating on equal terms, side by side. 

This result is pictured in Figure 15. The upper part 
(Fig. 15a) shows the situation before the introduction 
of free coinage of silver, and the lower part (Fig. 156) 
shows what will be the result if silver has been allowed to 
flow into circulation. In this case the film/ has been pushed 
only part way to the left, — to such a point as to bring the 
silver and gold levels into coincidence. As the film has 
been swept to the left, and more room has thus been made 
for silver, the silver level has fallen, while as the film has 
crowded out gold, the gold level has risen and the two levels 
have come into coincidence on the line mm. In other words, 
the premium on gold bullion has disappeared, and bimet- 
allism has, for the time being at least, succeeded. 

While such an equality in the value of gold and silver dol- 
lars continues, neither completely expels the other, although 
both are freely coined. If the levels of the two metals on 
opposite sides of the film / should, for a moment, differ 
slightly, the difference would be automatically corrected, for 
the cheaper metal having the higher level would simply crowd 
against the dearer metal having the lower level and the 
separating film / would need to shift only a little before the 
two levels would again coincide. For these reasons, no mat- 
ter which of the metals tends from time to time to become 
more plentiful and cheaper, and, therefore, to expel the other, 
the only result would be a slight shifting of the film. This 
will move from right to left or left to right, as the case maybe, 
but as long as it does not move completely to the right or 
the left limit, bimetallism will continue to be successful. 
The film being movable (that is, gold and silver being 
mutually replaceable as money), the three reservoirs act as 
one and keep a common level for all three. 

We see, then, that those are wrong who maintain that 
Gresham's Law always results in complete expulsion from 



232 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

circulation of one metal by the other. The expulsion can 
continue only so long as there is a difference in value between 
the two metals, but as the expelHng proceeds (that is, as 
the film / shifts) the very difference of level which shifts 
it tends to disappear. Sometimes (as in Fig. 14b) the film 
will be pushed to its extreme limit before the difference of 
level between the two hquids disappears, but sometimes 
on the other hand (as in Fig. i^b) the difference of level 
between the two liquids will disappear before the film reaches 
its limit. Which of these two results will happen, depends 
on circumstances. To distinguish the two cases we may 
suppose the Hne mm to be drawn in all of the four cases 
(Figs. 14a, 14b, 15a, 15&). This line is the mean level of the 
liquids in the reservoirs (that is, the common level which the 
liquids contained in the three reservoirs would find if inter- 
communication among them were entirely free). 

The case represented in Figure 14 is the case where the 
amount of silver bulHon x above the mean hne mm equals or 
exceeds the total capacity of the money reservoir below that 
line. In such a case, as soon as x is allowed to flow into the 
money reservoir it is sufficiently great to wholly displace all 
the gold in that reservoir. 

The case represented in Figure 15 is the case where 
the amount of silver bullion x above the hne mm is less 
than the total contents of the money reservoir below the 
line mm. In this case when x is given access to the 
money reservoir it is inadequate to wholly sweep gold out 
of circulation. 

The first case undoubtedly represents what would have 
happened in the United States if we had attempted free 
coinage of silver, at 16 to i, as proposed by one p.ohtical 
party in 1896 and 1900. It also represents what actually 
did occur in the United States after the adoption of the 
Bimetallic Law (at a ratio of 15 to i) in 1792. In that case 
it was gold which expelled silver. 



Sec. s] operation OF MONETARY SYSTEMS 233 

§ 5. Changes in Production and Consumption 

III. Thus far in our discussion we have taken no account 
of the production and consumption of the precious metals. 
We have taken account only of the distribution of the 
existing stocks of these metals as between money in circula- 
tion and gold and silver bullion. As has already been hinted, 
as soon as the first effects of free coinage have been felt and 
the existing available stock of silver has been coined, there 
will be at once a great stimulus to silver mining and dis- 
couragement to gold mining. If, for instance, as above sup- 
posed, before the introduction of bimetallism, the value of 
412^ grains of silver had been ninety-five cents in gold, but, as 
a consequence of the free coinage of silver, its value has im- 
proved to a dollar, it is evident that producers of silver will, 
in consequence of this rise in price of their product, be 
encouraged to mine a larger product than before the intro- 
duction of bimetallism. Through its new monetary use 
their market for silver has been greatly increased. At the 
same time the market for gold will have been decreased and 
its production discouraged. While the value of silver in terms 
of gold has increased, the value of gold in terms of silver 
has decreased, or, what is more to the point, while the value 
of silver in terms of goods in general has increased, the value 
of gold in terms of goods in general has decreased. We 
have already seen (in Chapter XII, § 4) that this decrease in 
the value of gold will discourage its production just as the 
increase in the value of silver will encourage its production. 

Since, then, the output of silver increases and that of 
gold decreases, there will be a still further expulsion of gold 
by silver. In the mechanical illustration some of the silver 
inlets at the right, formerly unused (below the liquid surface) 
will have been uncovered and will pour their streams into 
the reservoir Sh, while some gold inlets at the left formerly 
open will be submerged and cease their flow. Consequently, 
the film will be shifted toward the left. 



234 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

IV. But this movement of the film, or displacement of 
gold by silver, will not necessarily proceed far. The in- 
creased production of silver will tend to be self-limiting, for 
with increased production comes increased cost. The con- 
sumption of silver on the other hand may increase and over- 
take production; for the greater the stock of silver in 
circulation, the larger the amount which will be used up by 
abrasion, losses, etc. Therefore it may soon come about 
that the production and consumption of silver will again 
be equal. When this occurs the stock of silver will again 
be stationary. The same may happen to gold by the op- 
posite process. Its lessened production is self-limiting, for 
the mines where gold is most cheaply produced will con- 
tinue to operate at a profit ; moreover, the lessening in pro- 
duction will be followed by a lessening of stock, and the 
lessening of stock may lead to a lessening of consumption 
which may fall to equality with production. When this 
occurs the stock of gold will again be stationary. 

As a matter of fact, however, such ideal equilibrium, in 
which the stocks of both metals remain stationary, never 
occurs. Changes in production and consumption of the 
precious metals are constantly adding to and subtracting 
from the stocks of these metals in the form of money and 
bullion. Any such disturbance of the stocks of the precious 
metals will, as we have seen, tend to make one metal dis- 
place the other, but whether the displacement will be com- 
plete or not depends, as we have seen, upon circumstances. 

Consequently, the film will be driven to the right or the 
left as gold or silver flows in from one side or the other. In 
this way, by moving the film back and forth, bimetallism may 
remain in successful operation for a long time, as, in fact, it 
did in France for three fourths of a century ending in 1873. 
In this period gold and silver money circulated at par in 
France, sometimes silver partially displacing gold and 
sometimes gold partially displacing silver. Never until 
the end of the period did either completely displace the 



Sec. 6] 



OPERATION OF MONETARY SYSTEMS 



23s 



other. For a long time the film shifted back and forth 
without reaching its limit on either side. But such a fate 
is in the end almost inevitable. This is what happened in 
France in 1873. 

§ 6. The " Limping " Standard 

Bimetallism is to-day a subject of historical interest only. 
It is no longer practiced ; but its former prevalence has 
left behind it in many countries, including France and the 
United States, a monetary system which is sometimes 
called the " limping " standard. Such a system comes about 
when, in a system of bimetallism, before either metal can 
wholly expel the other, the mint is closed to the cheaper of 
them, but the coinage that has been accomplished up to 
date is not recalled. Suppose silver to be the metal thus 
excluded — as in France and the United States. Any 
money of that metal already coined and in circulation is 




Fig. 16. 



kept in circulation at par with gold. This parity may 
continue even if limited additional amounts of silver be 
coined from time to time. There will then result a differ- 
ence in value between silver bullion and silver coin, the 
silver coin being overvalued. This situation is represented 
in Figure 16. Here the pipe connection between the money 



236 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

reservoir and the silver bullion reservoir has been, as it 
were, cut off, or, let us say, stopped by a valve which re- 
fuses passage of silver from the bulUon reservoir to the 
money reservoir, but not the reverse (for no law ever can 
prevent the melting down of silver coins into bulHon). 
Newly mined silver cannot now become money, and thus 
lower the purchasing power of money. 

On the other hand, new suppKes of gold continue to affect 
the value of currency as before — the value, not only of 
the gold, but also of the concurrently circulating over- 
valued silver. If more gold should flow into the money 
reservoir, it would raise the currency level. Should this 
level ever become higher than the level of the silver bullion 
reservoir, silver would flow from the money reservoir into 
the bullion reservoir ; for the passage in that direction {i.e., 
melting) is still free. So long, however, as the money 
level is below the silver level, i.e., so long as the coined 
silver is worth more than the uncoined, there will be no flow 
of silver in either direction. The legal prohibition prevents 
the inflow of silver, and the loss which would be sustained 
by melting prevents its outflow. 

In the case just discussed, the value of the coined silver 
will be equal to the value of gold at the legal ratio. Pre- 
cisely the same principle applies in the case of any money 
the coined value of which is greater than the value of its 
constituent material. Take the case, for instance, of paper 
money. So long as it has the distinctive characteristic of 
money — general acceptability at its legal value — and is 
limited in quantity, its value will ordinarily be equal to that 
of its legal equivalent in gold. If its quantity increases 
indefinitely, it will gradually push out all the gold and 
entirely fill the money reservoir, just as silver would do 
under bimetallism if produced in sufficiently large amounts. 
Likewise credit money and credit in the form of bank 
deposits would have this effect. To the extent that they 
are used, they lessen the need for gold, decrease its value 



Sec. 6] OPERATION OF MONETARY SYSTEMS 237 

as money, and cause more of it to go into the arts or to 
other countries. 

So long as the quantity of silver or other token money, 
e.g., paper money, is too small to displace gold completely, 
gold will continue in circulation. The value of other 
money in this case cannot fall below that of gold. For if it 
should, it would by Gresham's Law displace gold, which we 
have supposed it is not of sufficient quantity to do. The 
parity between silver coin and gold coin, under this " limp- 
ing" standard is, therefore, not necessarily dependent on any 
redeemability in gold, but may result merely from Hmita- 
tion in the amount of silver coin. Such limitation is usually 
sufficient to maintain parity, despite irredeemability. This 
is not always true, however ; for if for any reason (such as 
its novelty and strangeness or rumors of further inflation) 
the people should not have confidence in some form of 
irredeemable paper or token money, even though it were 
not overissued, it would depreciate and be nearly as cheap 
in money form as it is in the raw state. It might even be 
so completely rejected that it would cease to circulate and 
cease to be money. A man is wilhng to accept money at its 
face value so long as he has confidence that every one else is 
ready to do the same. But it is possible, for instance, for a 
mere fear of overissue to destroy this confidence. The payee, 
who under ordinary circumstances submits patiently to 
whatever money is a customary or legal tender, may then 
take a hand and insist on " contracting out " of the offend- 
ing standard. That is, he may insist on making, all his 
future contracts in terms of the better metal — • gold, for 
instance — and thus contribute to the further downfall in 
value of the dspreciated paper. 

Irredeemable paper money, then, like our irredeemable 
silver dollars, may circulate at par with other money if 
limited in quantity and not too unpopular. If it is gradu- 
ally increased in amount, such- irredeemable money may 
expel all metallic money and be left in undisputed posses- 



238 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIII 

sion of the field. But though such a result — a condition 
of irredeemable paper money as the sole currency — is pos- 
sible, it has never proved desirable. On the contrary, irre- 
deemability is a constant temptation toward abuse, and this 
fact alone causes business distrust and discourages long-time 
contracts and enterprises. Irredeemable paper money has 
almost invariably proved a curse to the country employing 
it. While, therefore, redeemability is not absolutely essen- 
tial to produce parity of value with the primary money, it 
is practically a wise precaution. 

The lack of redeemability of silver dollars in the United 
States is one of the chief defects in our unsatisfactory 
monetary system. Our paper silver certificates are re- 
deemable in silver dollars, but these silver dollars are not 
redeemable in gold. The absurdity of the situation consists 
in the fiction that somehow the redemption of the silver cer- 
tificates in silver dollars keeps them both at par with gold. 
The truth is that the paper would keep its parity with 
gold just as well if there were no redemption in silver. 
A silver dollar as silver is worth less than a gold dollar just 
as truly as a paper dollar, as paper, is worth less than a 
gold dollar. The fact that the silver is worth half a dollar, 
while the paper is worth only a fraction of a cent, will not 
avail in the least to make either the silver or the paper 
worth a whole dollar, A pillar which reaches halfway to 
the ceiling cannot hold the ceiling up any more than a 
pillar an inch high. The silver certificates and silver dol- 
lars keep at par with gold merely because they are not 
sufiicient in quantity to displace gold. If their quantity 
should ever be made great enough, they would displace gold 
and depreciate ; and the redeemability of one of them in 
the other will not avail to prevent such depreciation. 

The system of the limping standard, now obtaining in 
the United States and some other countries, logically forms 
a connecting link between- complete bimetallism and those 
" composite " systems by which any number of different 



Sec. 6] OPERATION OF MONETARY SYSTEMS 239 

kinds of money may be simultaneously kept in circulation. 
Most modern civilized states have solved the problem of 
concurrent circulation by using gold as a standard and 
silver, nickel, and copper chiefly as a subsidiary money, 
limited in quantity, with, in most cases, limited amounts 
of paper money, the latter being usually redeemable. The 
possible variations of this composite system are unlimited. 
In the United States at present we have a system which 
is very complicated, consisting of gold dollars freely coined, 
silver dollars, fractional silver, minor coins of nickel and of 
copper. United States notes, national bank notes, gold cer- 
tificates and silver certificates. The system is not only com- 
plicated, but objectionable in many of its features, especially 
in its lack of elasticity, which characteristic is due to the 
fact that national bank notes are based upon the inelastic 
national debt rather than upon the elastic general assets 
of the bank. 



CHAPTER XIV 

CONCLUSIONS ON MONEY 

§ I. Can "Other Things Remain Equal"? 

The chief purpose of the preceding six chapters is to set 
forth the causes determining the purchasing power of money. 
This purchasing power has been studied as the effect of 
three, and only three, groups of causes. The three groups 
center on currency, on its velocity, and on the volume of 
trade. These and their effects, namely, prices, we saw to be 
connected by an equation called the equation of exchange, 
MV + M'V' — ^pQ- The three causes, in turn, we found 
to be themselves effects of antecedent causes lying entirely 
outside of the equation of exchange, as follows : the volume 
of trade will be increased, and therefore the price level 
correspondingly decreased by the differentiation of human 
wants ; by diversification of industry ; and by facilitation 
of communication. The velocities of circulation will be in- 
creased, and therefore the price level increased by improv- 
ident habits ; by the use of book credit ; and by rapid 
transportation. The quantity of money will be increased, 
and therefore the price level increased, by the import and 
minting of money, and, antecedently, by the mining of the 
money metal ; by the introduction of another and initially 
cheaper money metal through bimetallism ; and by the issue 
of bank notes and other paper money. The quantity of 
deposits will be increased, and therefore the price level 
increased, by extension of the banking system and by the 

240 



Sec. i] conclusions ON MONEY 24 1 

use of book credit. The reverse causes produce, of course, 
reverse effects. 

Thus, behind' the three sets of causes which alone affect 
the purchasing power of money, we find over a dozen ante- 
cedent causes. If we chose to pursue the inquiry to still 
remoter stages, the number of causes would be found to 
increase at each stage in much the same way as the number 
of one's ancestors increases with each generation into the 
past. In the last analysis myriads of factors play upon the 
purchasing power of money ; but it would be neither feasible 
nor profitable to catalogue them. The value of our analysis 
consists rather in simplifying the problem by setting forth 
clearly the three proximate causes through which all others 
whatsoever must operate. At the close of our study, as at 
the beginning, stands forth the equation of exchange as the 
great determinant of the purchasing power of money. With 
its aid we see that normally the quantity of deposit currency 
varies directly with the quantity of money, and that there- 
fore the introduction of deposits does not disturb the re- 
lations we found to hold true before. That is, it is still true 
that (i) prices vary directly as the quantity of money, pro- 
vided the volume of trade and the velocities of circulation 
remain unchanged; (2) that prices vary directly as the 
velocities of circulation (if these velocities vary together), 
provided the quantity of money — and therefore deposits 
— and the volume of trade remain unchanged ; and (3) that 
prices vary inversely as the volume of trade, provided the 
quantity of money and therefore deposits and the veloc- 
ities of circulation remain unchanged. 

But the question now arises, Can the factors supposed 
to "remain unchanged" in these three cases actually remain 
unchanged? To this question the answer is, "Yes, with 
one exception." A change in the volume of trade per 
capita seems to affect, besides prices, the velocities of 
circulation, so that these velocities cannot " remain un- 
changed." At a given price level, the greater the per 



242 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIV 

capita trade, the more rapid is the individual turnover. 
Statistics seem to show this. 

Thus an increase in trade, unlike an increase in currency 
or in velocities, may have other effects than simply on 
prices; for, in fact, it may increase the magnitudes on 
the opposite side of the equation. But with this exception 
and apart from transition periods, the three groups of 
magnitudes which determine the price level — (i) money 
and deposits, (2) their velocities, (3) volume of trade — are 
independent of each other. That is to say, a change in 
the quantity of money, — and therefore of deposits, — 
though it may temporarily affect velocities and trade, wUl 
not do so in the long run. Instead it will expend all its 
effects on prices, which wUl therefore change in the same 
proportions. Similarly, a change in velocities, though it 
may temporarily affect money and deposits as well as 
trade, will not do so in the long run, but will also expend 
all its effects on prices. 

The proof of these conclusions consists simply in the fact 
that investigation fails to show any other relations among 
the factors in the equation of exchange than those 
which have been mentioned. 

§ 2. An Increase of Money does not Decrease its Velocity 

It cannot be shown, for instance, that (except during 
transition periods) there is any tendency for an increase in 
the quantity of money to decrease its velocity of circulation. 
Some persons who have never investigated the subject 
imagine that if money were suddenly doubled in quantity, 
prices need not rise at all, as the effect might be simply to 
cut the velocity of circulation in two. This would be true 
if the public should, for some unaccountable reason, decide 
to carry double the former quantity of money while expend- 
ing precisely the same amounts, but we have found that the 
velocity of circulation of money is determined by the habits 
of the people. They find for themselves what is the most 



Sec. 2] CONCLUSIONS ON MONEY 243 

convenient amount to carry in order that it shall be best 
adapted to meet their particular expenditures. If, then, 
money and expenditure are mutually adjusted to suit the 
convenience of the people, this implies that any increase in 
the amounts carried would (for a given price level) be 
inconveniently large. 

To make the picture definite, let us suppose that the aver- 
age per capita amount of money in actual circulation in the 
United States, outside of the United States Treasury and 
the banks, is about $15, and that some mysterious Santa 
Claus suddenly doubles the amount in the possession of 
each individual. This means that the average individual 
will have $30 where before he had $15. Now, statistics 
show that the average per capita amount in circulation 
changes only sHghtly from month to month. While the 
amount of money carried by an individual will necessarily 
fluctuate because of his expenditures and receipts, in a large 
group of people the average amount carried by the several 
individuals composing the group will fluctuate but little. 
If, then, so large an addition to the total circulation is 
suddenly made as to put fifteen extra dollars per capita in 
the hands of the public, the first thought of most people will 
be how to get rid of this inconvenient addition to the money 
which they are carrying. If they should be inclined to hoard 
it in stockings or safes or to bury it in the earth or to drop 
it into the sea, it would have no tendency to raise prices. 
Instead, however, they will seek to make some use of it 
either by expending it for goods or by depositing it in banks. 
Thus a few days after the supposed visit of Santa Claus, the 
surprised recipients of the extra money will, in most cases, 
have disposed of it in one of these two ways. To the extent 
that they dispose of it in the first way — in the purchase of 
goods — it is evident that there will be a tendency to raise 
prices, for the sudden expenditure of $15 per capita, even 
by a small fraction of the people of the United States, wiU 
mean a phenomenal rush upon the shops. 



244 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIV 

The average individual does not expend in actual money 
more than $15 in two weeks. This is about a dollar a day, 
or about $100,000,000 a day for the entire country. If 
within, let us say, five days from his windfall of $15 the 
average man should try to spend this extra sum, the result 
would be $3 per day per capita, or $300,000,000 a day for the 
nation. This, in addition to the usual $100,000,000 a day, 
would make $400,000,000 a day, or four times the ordinary 
rate of expenditure. Such a sudden briskness in trade 
would astonish the shopkeepers and lead them promptly to 
raise their prices; otherwise, in many cases their stocks 
would be entirely depleted. 

At first sight, it might seem that it would only require a 
few days for each one to get rid of his extra money so that 
the flurry in prices would, therefore, be only temporary; 
but such reasoning would be fallacious; for we must not 
forget that the only way in which the individual can get rid of 
his money is by handing it over to somebody else. Society 
is not rid of it. If the shopkeepers, who under our Santa 
Claus h3^othesis have already had their till money doubled 
mysteriously, receive in addition the surplus cash of their 
customers, they will now be the ones embarrassed with a 
surplus of cash and will, in their turn, endeavor to get rid 
of it, by purchasing goods for their business or by depositing 
it in banks. Since, then, the effort to get rid of money by 
transferring it merely results in somebody else having a 
surplus, the surplus in the community remains unchanged. 
Therefore, the effort to get rid of it and the consequent effect 
on prices will continue until prices have reached a sufficiently 
high level. 

This conclusion cannot be avoided by supposing that 
most of the money is not spent in trade, but deposited in 
banks. The bankers whose deposits are thus suddenly 
swollen will now be the ones who will strive to get rid of the 
surplus cash. No banker wishes to have idle reserves, and 
each will make the increase in reserves the basis for an in- 



Sec. 2] CONCLUSIONS ON MONEY 245 

crease of business, including an increase of deposits. We have 
seen that this tendency results ultimately in preserving the 
relative amounts of the three magnitudes : money in circula- 
tion, money in bank reserves, and deposits based on these re- 
serves. In the end, then, the doubhng of society's money will 
mean a doubling (i) of the money in circulation, (2) of the 
money in banks, and (3) of the deposits based on this money. 
In a short time it will also mean a doubhng of prices, for as 
long as prices fail to be double what they were, there will 
be the same phenomenon of inconvenient surpluses. Indi- 
viduals, tradesmen, bankers, etc., will be trying to get rid 
of these surpluses, and their efforts to get rid of them must 
tend to raise prices. When, however, prices have reached 
double their original level, there will be no longer any effort 
to get rid of surplus cash ; for there will be no surplus cash. 
The $30 per capita which has thus been created will no 
longer seem excessive, in view of the fact that prices are 
double what they formerly were and that the persons carry- 
ing this money will, on the average, find their wages or 
incomes doubled likewise. Thus, if formerly the average 
individual was accustomed to spend $300 and to carry an 
average balance of $15, he will now spend $600 and carry 
an average balance of $30. The adjustment of the $30 to 
$600 is exactly the same as the former adjustment of the 
$15 to $300. In either case the relation is one to twenty, 
which means that the individual turns his money over, on the 
average, twenty times a year. Thus, in the end, a doubling 
of the quantity of money does not expend its effect in dis- 
turbing the velocity of circulation, but in raising the general 
level of prices. 

It is worth noting that the imaginary example we have 
given represents, except in its details, exactly what actually 
happens when new gold is discovered. Gold miners convert 
their product into money, sometimes using it as such in the 
form of nuggets or gold dust and sometimes taking it to the 
mint and converting it into coin. They find themselves in 



246 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIV 

possession of bags full of money far beyond what they need 
as the most convenient amount of pocket money. If, for 
instance, one of these men has just received from the mint 
a thousand dollars in gold, he is almost sure to get rid of 
at least $950 of it as speedily as possible, either by spending 
it or by depositing it in the bank. In either case, he and 
the hundreds of others who are doing the same thing tend to 
raise prices in the community where they are spending their 
money or where they and others spend checks on the banks 
in which they deposit their money. 

It was thus that prices rose in the mining camps of Cali- 
fornia a half dozen decades ago and one or two decades ago 
in Colorado and the Klondike. This local rise of prices then 
communicated itself to other places; for, as we have seen, the 
price level cannot in one locality greatly exceed that in a 
neighboring locality without causing an export of money 
to the cheaper locality. Thus, new money gradually finds 
its way into circulation throughout the world, raising prices 
as it flows from place to place, the process consisting in 
all cases of the effort to get rid of an inconvenient surplus and 
one which cannot be permanently got rid of by transferring 
it from hand to hand, but only by a rise of prices. 

This picture of the manner in which an increase of money 
causes a rise of prices is here given to show clearly that an 
increase in the amount of money {M) does not result in a 
mere decrease in its velocity (F). Its velocity depends, not 
on its quantity, but on the factors given in Chapter XI, 

§§ 3, 4, 5- 

In the same way it might be shown that an increase in the 
quantity of money will not affect the velocity {V) of circu- 
lation of bank deposits nor the volume of trade (the Q's). 
It will merely affect the volume of deposits {M') and the 
level of prices (P). 

A change of M does not, of course, prevent other causes 
from at the same time affecting M\ V, V\ and the Q's, and 
thus aggravating or neutralizing the effect of M on the ^'s. 



Sec. 3] CONCLUSIONS ON MONEY 247 

But these are not the effects of M. So far as M by itself is 
concerned, its effect is only on M' and the p's> and is propor- 
tional to its quantity. The importance and reality of this 
proposition is not diminished in the least by the fact that 
these other causes do not, as a matter of fact, remain qui- 
escent and allow the effect on the ^'s of an increase in M 
to be seen separately from effects of other causes. The 
effects of changes in M are blended with the effects of 
changes in the other factors in the equation of exchange, 
just as the effects of gravity upon a falling body are 
blended with the effects of the resistance of the atmosphere. 

Our main conclusion, then, is that we find nothing to 
interfere with the truth of the quantity theory : that varia- 
tions in money (M) produce, normally, proportional changes 
in prices. 

We have now finished with the principles determining 
the purchasing power of money. By the aid of these prin- 
ciples the student should be able to avoid hereafter most 
of the fallacies and pitfalls which beset the subject. He 
will find it a useful exercise to turn back to Chapter I and 
test himself by analyzing as many as he can of the money 
fallacies there stated. The others we hope to clear up in 
later chapters. 

§ 3. An Index Number of Prices 

We have been studying the causes determining the pur- 
chasing power of money, or its reciprocal, the level of prices. 
Hitherto we have not defined exactly what a " general level " 
of prices may mean. There was no need of such a definition 
so long as we assumed, as we have usually done hitherto, 
that all prices move in perfect unison. But practically, 
prices never do move in perfect unison. If some ^'s do not 
rise enough to preserve our equation, others must rise more. 
If some rise too much, others must rise less. The case is 
further complicated by the fact that some prices cannot 



248 ELEMENTARY PRINCIPLES OF ECONOMICS [ChAP. XIV 

adjust themselves at all and some can adjust themselves 
but tardily. A price fixed by contract cannot be affected 
by any change coming into operation between the date 
of the contract and that of its fulfillment. The existence of 
such contracts constitutes one of the chief arguments for a 
system of currency such that the uncertainties of its pur- 
chasing power are the least possible. Contracts are a 
useful device ; and an uncertain monetary standard dis- 
arranges them and discourages their formation. Even in 
the absence of explicit contracts, prices may be kept from 
adjustment by implied understandings and by the mere 
inertia of habit. And besides these restrictions on free 
movement of prices there are often legal restrictions; as, 
for example, when railroads are prohibited from charging 
over two cents per passenger per mile, or when street rail- 
ways are limited to five-cent or three-cent fares. What- 
ever the causes of non-adjustment, the result is that the 
prices which do change will have to change in a greater ratio 
than they would were there no prices which do not change. 
Just as an obstruction put across one half of a stream 
causes an increase of current in the other half, so any de- 
ficiency in the movement of some prices must cause an 
excess in the movement of others. 

Another class of goods, the price of which cannot fluctu- 
ate greatly with other prices, are those special commodi- 
ties which consist largely of the money metal. Thus, in a 
country employing a gold standard, the prices of gold for 
dentistry, of gold rings and ornaments, gold watches, gold- 
rimmed spectacles, gilded picture frames, etc., instead of 
varying in proportion to other prices, always vary in a 
smaller proportion. The range of variation is the nar- 
rower, the more predominantly the price of the article de- 
pends upon the gold as one of its raw materials. 

From the fact that gold-made articles are thus more or 
less securely tied in value to the gold standard, it follows 
also that the prices of substitutes for such articles will tend 



Sec. 3] CONCLUSIONS ON MONEY 249 

to vary less than prices in general. These substitute articles 
will include silver watches, ornaments of silver, and various 
other forms of .jewelry, whether containing gold or not. 

A further dispersion of prices is produced by the fact that 
the special forces of supply and demand are playing on 
each individual price, and causing relative variations among 
them, and although these variations cannot affect the 
general price level they can affect the number and extent 
of individual divergencies above and below that general 
level. 

It is evident, therefore, that prices must constantly 
change relatively to each other, whatever happens to their 
general level. It would be as idle to expect a uniform move- 
ment in prices as a uniform movement for all bees in a swarm. 
On the other hand, it would be as idle to deny the existence 
of a general movement of prices because they do not all 
move alike as to deny a general movement of a swarm of 
bees because the individual bees have different movements. 
The general movement of prices is expressed by an "index 
number " which gives the average level of prices at any time 
as compared with some other time used for comparison. 

Besides the changes in individual prices, there will be 
corresponding changes in the quantities of the commodities 
which are exchanged at these prices respectively. In other 
words, as each p changes, the Q connected with it will 
change also, because usually any influence affecting the 
price of a commodity will also affect the consumption of it. 

We see, therefore, that it is well-nigh useless to speak of 
uniform changes in prices {p's} or of uniform changes in 
quantities exchanged (<3's). Therefore, instead of sup- 
posing such uniform changes, we must now proceed to the 
problem of developing some convenient method of indicating 
by an average the general trend of the changes in prices or in 
quantities. We must formulate two composite or average 
magnitudes : the price level (index number) and the vol- 
ume of trade. 



250 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XIV 

It is desired, then, in the equation of exchange, to con- 
vert the right side, 2^Q, into the form PT, where T measures 
the volume of trade, and P is the " index number " ex- 
pressing the price level at which this trade is carried on. 

T is conceived as the sum of all the Q'z, and P as the 
average of all the ^'s. 

To carry out these definitions in practice, suitable units 
of measure for the various articles must be selected. The 
ordinary units in which the various Q's are measured will 
not be the most suitable. Coal is sold by the ton, sugar 
by the pound, wheat by the bushel, etc. If we should 
merely add together these tons, pounds, bushels, etc., and 
call their grand total so many " units " of commodities, we 
should have a very arbitrary summation. It will make a 
difference to the result whether we measure coal by tons 
or hundredweights. The system becomes less arbitrary 
and more useful for the purpose of comparing price levels 
in different years if we use, as the unit for measuring any 
commodity, not the unit in which it is commonly sold, but 
the amount zvhich constitutes a " dollar^ s worth" at some partic- 
ular year called the base year. Then every price in the base 
year becomes exactly one dollar, and the average of all 
prices in that year also becomes exactly one dollar. In any 
other year, the average price {i.e., the average of the prices 
of the arbitrarily chosen units which in the base year were 
worth a dollar) will be the index number representing the 
price level, while the number of such units will be the volume 
of trade. Thus, let us suppose, for simpHcity, that there 
are only three commodities (bread, coal, and cloth), and let 
us use the table on the next page for facts to start with. 

We wish to compare the average price or price level in 
the year 191 2 with that in 1909 as the base year, and 
also to reckon the total volume of trade in 191 2 in com- 
parison with that in 1909. If we were not desirous of taking 
great pains to secure the best results, we could use the above 
figures just as they stand — averaging the prices and adding 



Sec. 3] 



CONCLUSIONS ON MONEY 



251 



together the quantities. By this rough-and-ready method 
the average price per unit for 1909 would be (.10 + 5.00 





Prices (in Dollars) 


Quantities Exchanged 


Yeak 


Bread (per 
Loaf) 


Coal (per 
Ton) 


Cloth (per 
Yard) 


Bread (Mil- 
lions of 
Loaves) 


Coal (Mil- 
lions of 
Tons) 


Cloth (Mil- 
lions of 
Yards) 


1909 . . 
1912 . . 


.10 
•IS 


5.00 
6.00 


1. 00 
1. 10 


200 
210 


10 
II 


30 
35 



+ i.oo) H- 3, or $2.03 ; and for 1912 (.15 -|- 6.00 -|- i.io) -f-3, 
or $2.42 ; the total trade for 1909 would be 200 -f- 10 + 30, 
or 240 milUon units; and for 1912, 210 -|- 11 -f 35, or 256. 
That is, the price level would show a rise between 1909 and 
1912 from $2.03 to $2.42, or a rise of nineteen and two tenths 
per cent, while the volume of trade would show a rise from 
240 to 256, or six and six tenths per cent. But the simple 
method just used gives too much weight in the price 
comparison to coal, the price of which happens to be 
expressed by a large number simply because it is measured 
by a large unit. One way to remedy this disproportionate 
weighting is to measure all articles by one unit, as the 
pound ; but a better way is that already described above, 
viz., to use as our unit " the dollar's worth in 1909." The 
dollar's worth of bread in 1909 was evidently ten loaves, 
the dollar's worth of coal, the fifth of a ton, and that of 
cloth, the yard. Taking these units, we now have : — 





Prices (in Dollars) 


Quantities 


Year 


Bread (per 
Ten Loaves) 


Coal (per 
iTon) 


Cloth (per 
Yard) 


Bread (Mil- 
lions of Ten 
Loaves) 


Coal (Mil- 
lions of J 
Tons) 


Cloth (Mil- 
lions of 
Yards) 


1909 . . 
1912 , . 


I.OO 

i-So 


I.OO 

1.20 


I.OO 
I.IO 


20 
21 


50 
SS 


30 
35 



252 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIV 

The average price in 1909, on the basis of these new units, 
is simply $1, since this is the price of each individual article ; 
while the average price in 191 2 is — if we take the simple 
arithmetical average — ($1.50 + $1.20 + $1.10) -i- 3, or $1.27. 
The total volume of trade in 1909 is (in millions of units) 
20 + 50 + 30, or 100; and in 1912,. 21 + 55 +35, or iii. 
Thus, according to this reckoning, the price level has risen 
from $1.00 to $1.27, or, as it is usually expressed, from a base 
of one hundred per cent to a height of one hundred and 
twenty-seven per cent — a rise of twenty-seven per cent; 
while trade has increased from 100 million units to in 
million units, an increase of eleven per cent. 

We may slightly improve the above method by taking 
for 1 91 2 a "weighted" average of prices instead of a 
simple average. It is foimd by dividing the total value of 
all the goods by their total quantity. This is a better 
method because, in the result, it gives less weight to the 
commodities less dealt in, such as bread. The average for 
1909 will still be $1.00, for that is the price for each in- 
dividual commodity; but the average for 191 2 will be 
shghtly different. The total value is (in milHons of dollars) 
1.50 X 21 + 1.20 X 55 + 1. 10 X 35, or 136 million dollars, 
and the total quantity is, as we have already seen, 21 -f 55 
-f- 35, or III million units; consequently the average price 
is 136 -T- III, or $1.23. According to this last and best 
method, then, the price level has risen from $1 (or one 
hundred per cent) to $1.23 (or one hundred and twenty- 
three per cent) ; this indicates a rise of twenty-three per 
cent. The index numbers are one hundred per cent for 
1909 and one hundred and twenty- three per cent for 191 2. 

The results of the three methods of reckoning the average 
rise of prices differ slightly, showing respectively a rise of 
nineteen, twenty-seven, and twenty-three per cent. Other 
methods, of which many are possible, would also differ 
slightly. No method gives an absolutely perfect index of 
changes in price levels, but the last one worked out above is 



Sec. 4] CONCLUSIONS ON MONEY 253 

as good as any. The main point in any system of averages 
is to give great weight to the great staples of trade, and little 
weight to the insignificant articles. Radium has fallen 
in price enormously in the last few years, but radium is 
so unimportant as an article of commerce that its great 
fall ought not to be allowed in our reckoning to have 
much effect on the index number for the general price 
level. 

Introducing, then, our newly found magnitudes, P and 
T, into the equation of exchange, it assumes the form 

MV + M'V' = PT, 

its right member being the product of the index number, 
P (or the average of prices) , multiplied by the volume of 
trade, T (or the sum total of " units " sold). 

§ 4. The History of Price Levels 

It is impossible to have absolutely accurate index num- 
bers, but those constructed for recent years by the United 
States Bureau of Labor are accurate enough for all practical 
purposes. For the remote past we have only very rough 
index numbers, because the records of prices in past times 
are so defective. These rough index numbers are suffi- 
cient, however, to show that the general trend of prices dur- 
ing the last ten centuries has usually been upward. We 
may say that prices are now five to ten times as high as a 
thousand years ago. Since the discovery of America, prices 
have almost steadily risen. The successive opening of 
mines has been largely responsible for this rise. 

For recent years (1896-1910) we are able to construct 
fairly accurate estimates of all the factors in the equation 
of exchange, M, M' , V, V' , P, T. The statistics of these 
magnitudes for the fifteen years mentioned are all presented 
in Figure 17. In this diagram the equation of exchange 



254 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIV 

for each year is represented by the mechanical balance 
described in a previous chapter. 

We note that in the years considered every factor has 
greatly increased. The quantity of money in circulation 
(M, represented by the purse) has about doubled; bank 
deposits subject to check (M', represented by the bank 
book) have about trebled; the volume of trade {T, repre- 
sented by the weight at the right) has about doubled ; the 
velocity of circulation of money (F, represented by the 
leverage of the purse, or its distance from the fulcrum) has 
increased slightly, and the velocity of circulation of bank 
deposits ( V', represented by the leverage of the bank book) 
has increased considerably. As the net result of these 
changes, the index number of prices (P, or the leverage of 
the weight at the right) has increased about two thirds. 
As in the above illustration, the price level of 1909 is taken 
as 100%. On this scale the price level of 1896 is 60%, and 
that of the other years, as indicated. The volume of trade 
for any year is represented as the number of " dollars' 
worth " on the basis of the prices in 1909. Thus the actual 
value of trade in 1909 was $387,000,000,000, or over a bil- 
lion a day, i.e., 387 billion units of goods of various kinds, 
the units being such as to be each worth one dollar in 1909. 
The trade in 1910 was 399,000,000,000 of these same units 
(i.e., such as were worth $ i in 1909). Similarly, the trade 
in 1896 was 191,000,000,000 of these units. As the index 
number of prices shows that the price level of 1896 was 
only about sixty per cent of the price level of 1909, the actual 
value of the trade in 1896 was only $114,600,000,000. 
This is PT for 1896, i.e., 191 billion units (each worth $1 
in. 1909) at 60 cents each, the price in 1896. 

Let us express the matter in terms of cause and effect. 
The diagram affords a picture of the fact that the increases 
in money and deposits and in their velocities (represented, 
respectively, by the increased weights of purse and bank 
book, and their increased distances from the fulcrum) have 



Sec. 4] CONCLUSIONS ON MONEY 255 

necessitated an increase in average prices (represented by the 
increased distance of the tray from the fulcrum) in spite of 
the increased volume of business which has been transacted 
(represented by the increased weight of the tray). 

It is interesting to observe the changes in all the factors 
before and after the crisis of 1907. These changes, it will 
be noted, fulfill the principles explained in the chapter on 
crises. 

From 1896 to the present time, the extraordinary increase 
in the world's gold production, chiefly in South Africa, 
Cripple Creek, and other parts of the Rocky Mountain 
Plateau, together with the Klondike region, has caused, 
and is still causing, a rapid rise of prices. 

The history of prices has in substance been a race between 
the increase in media of exchange {M and M') and the 
increase in trade {T), while the velocities of circulation 
have changed in a much less degree. Sometimes the 
circulating media shoot ahead of trade, and then prices 
rise. Sometimes, on the other hand, circulating media 
lag behind trade, and then prices fall. 

The outlook for the future apparently promises a con- 
tinued rise of prices due to a continued increase in the gold 
supply and in the use of deposit banking. 

The most careful review of present gold-mining conditions 
shows that we may expect a continuance of gold inflation 
for a generation or more. De Launay, an excellent authority, 
says, " For at least thirty years we may count on an output 
of gold higher than, or at least comparable to, that of the 
last few years." This gold will come from the United 
States, Alaska, Mexico, the Transvaal, and other parts of 
Africa and Australia, and later from Colombia, Bolivia, 
Chili, the Ural Province, Siberia, and Korea. 

It is difficult to predict the future growth of trade, and 
therefore impossible to say for how long gold and deposit 
expansion will keep ahead of trade. That for many years, 
however, they will outrun trade seems probable, for the 



256 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XIV 

reason that there is no immediate prospect of a reduction 
in the percentage growth of money and deposits, nor an 
increase in the percentage growth of trade. Not only do 
mining engineers report immense workable deposits in out- 
lying regions, but any long look ahead must reckon with 
possible and probable cheapening of gold extraction. The 
cyanide process, for instance, has made low-grade ores pay 
which did not pay before. If we let imagination run a 
little ahead of our times, we may expect similar improve- 
ments in the future whereby still lower grades may be 
worked, or the gold bearing clays of the South made to 
pay, or possibly even the sea compelled to give up its gold. 
Like the surface of the continents, the waters of the sea con- 
tain many thousand times as much gold as all the gold thus 
far extracted in the whole history of the world. We have 
seen that inflation is, in general, an evil, likely to culminate 
in a crisis. It is therefore to be hoped that the knowledge 
of how to get this hidden treasure may be secured but 
gradually, — unless its sudden acquisition may give the 
needed stimulus to governments to devise a more scientific 
standard of value than the yellow metal. 

It is unfortunate that the purchasing power of money 
should be always at the mercy of every chance in gold 
mining. There are few enterprises more subject to chance 
than gold mining. There are always chances of finding 
new gold deposits, chances of their " panning out " well or 
ill, and chances of new methods of metallurgy. On these 
fitful conditions the purchasing power of money is dependent. 
Consequently every one interested in long-time contracts, 
whether debtor or creditor, stockholder or bondholder, wage 
earner or savings bank depositor, is made to some extent 
a partaker in these chances. In a sense every one of us who 
uses gold as a standard for deferred payments becomes a 
gold speculator. We all take our chances as to what the 
future dollar will buy. The problem of making the pur- 
chasing power of money stable so that a dollar may he a 



Seg 4] CONCLUSIONS ON MONEY 257 

dollar — the same in value at one time as another — is one 
of the most serious problems in applied economics. As yet 
it has received- very little attention. The advocates of 
bimetallism have claimed that " the bimetallic standard " 
possesses greater stability than either the gold or silver 
standard. Many other and very ingenious schemes for 
a more stable currency have been proposed, but have re- 
ceived very little attention. As the consideration of these 
schemes belongs to applied economics, we shall not discuss 
them here. 



CHAPTER XV 

SUPPLY AND DEMAND 

§ I. Individual Prices Presuppose a Price Level 

We have completed our study of the purchasing power of 
money, which, as has been noted, is really a study of price 
levels. Our next topic will be individual prices. Prices, 
as we find them in the market, are facts of everyday ex- 
perience. As students of economics, we are seeking the 
explanation of these facts. Why, for instance, is the 
price of sugar six, cents a pound at one time and seven or 
five at another ? 

It has already been shown (Chapter VIII, § i) that 
individual prices, such, for instance, as the price of sugar, 
presuppose a price level. This fact is one reason why we 
have considered price levels before considering individual 
prices. Before proceeding to the causes determining in- 
dividual prices, it will be advisable to explain more fuUy 
this proposition that an individual price presupposes a price 
level. 

The price of sugar is a ratio between sugar and money. 
Any one who buys sugar balances in his mind the impor- 
tance of the sugar to him against the importance of the 
money which he has to pay for it. In making this com- 
parison, the money stands in his mind for the other things 
which it might buy if not spent Jar sugar. If this general 
purchasing power of money is great, money wiU seem 

258 



Sec. i] supply AND DEMAND 259 

precious in his mind, and he will be more loath to part 
with a given amount of it than if its purchasing power is 
small ; that is, the greater the power of money to purchase 
things in general, the less of it will be offered for sugar in 
particular, and the lower the price of sugar will therefore 
become. In other words, the lower the general price level, 
the lower will be the price of sugar. In still other words, 
the price of sugar must sympathize with prices in general. 
If they are high, it will tend to be high, and if they are low, 
it will tend to be low. Before the purchaser of sugar can 
decide how much money he is willing to exchange for it, 
he must have some idea of what else he could buy for his 
money. This explains why a traveler feels at first so help- 
less in a foreign country when he is told the prices of goods 
in terms of unfamiHar units. If the traveler has never 
heard before of kroner, gulden, rubles, or milreis, any 
prices expressed in these units will mean nothing to him. 
He cannot say how many of any one of these units he is 
willing to pay for any given article until he knows how the 
purchasing power of that unit compares with the unit to 
which he is accustomed. There must thus always be in 
the minds of those who use money some idea of its pur- 
chasing power. The sellers and buyers of sugar express the 
prices at which they are willing to supply or to demand in 
terms of money, and money means to them merely pur- 
chasing power over other things. It is often said that supply 
and demand of sugar or of any other commodity determine 
its price, and this is true, at a given price level; for those 
who supply or demand sugar, in deciding how much 
money they will take or give for it, are influenced by their 
idea of the general purchasing power of money. This 
needs emphasis because it is so often overlooked. Although 
the purchasing power of money is assumed, we are usually 
as unconscious of it as we are of the background of a picture 
against which we see and unconsciously measure the figures 
in the foreground. 

/ 



26o ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 



§ 2. A Market and Competition 

The terms " supply " and " demand," say, of sugar, 
thus imply a concealed reference to the purchasing power 
of money, i.e., to prices in general, as well as to the price of 
sugar in particular. As we have, through several previous 
chapters, already studied the subject of prices in general, 
we shall hereafter assume that the general level of prices 
has been determined in accordance with the principles set 
forth in those chapters relating to the equation of exchange. 
We are now ready to leave these general relations and to 
study the determination of a particular price (such as that 
of sugar) so far as this depends upon its own particular 
supply and demand in its own particular market. 

A market for any good is any assemblage of buyers and 
sellers of that good. The buyers and sellers may be, and 
usually are, physically near each other, as on the New York 
Stock Exchange, or they may be merely connected by tele- 
graph, telephone, or other means of communication, as in 
the stock market as a whole; for the stock market as a 
whole includes not only the members of the stock exchange, 
but also all other buyers and sellers of stock both in and 
out of the city. It is in the market that questions of supply 
and demand which we are about to discuss work them- 
selves out. 

Our study of price determination will fall under two 
heads, according as there is competition or monopoly. 
For the present we shall assume a condition of perfect 
competition; that is, we shall assume that there are a 
number of buyers and sellers each of whom offers to buy 
or sell independently of the others. Thus, if self-interest 
leads him to do so, a buyer will bid a higher price than 
others, irrespective of their wishes in the matter, and 
likewise a seller will ask a lower price if his independent 
self-interest so leads him. 



Sec. 3] SUPPLY AND DEMAND 26 1 

When there is perfect competition, there is (in a given 
market) only one resuhant price for all buyers and all 
sellers. This is evident ; for if there were more than one 
price, no buyers would buy at any of the higher prices 
which had first been asked (and so these must fall) , and no 
seller would sell at the lower prices which had been bidden 
(and so these must rise). The watchfulness of one com- 
petitor toward the others will eliminate differences in 
price. Even though not all buyers and sellers are careful 
to note slight differences in price, the more watchful bring 
about the same result by the operation of what is called 
"arbitrage." They buy at the lowest prices and sell at 
the highest. Their buying raises the lowest prices, and 
their selling lowers the highest. 

In these ways differences in prices are reduced or entirely 
eliminated. It is true that in practice there often remain 
slight differences in price, even in the same or closely as- 
sociated rnarkets. This fact merely means that competi- 
tion is often imperfect. In our discussion we shall not take 
account of those cases, but consider only the simple case 
where competition is perfect. 

§ 3. Demand and Supply Schedules 

The terms " supply " and " demand " have a definite and 
technical meaning in economics, and the reader should note 
the following definitions carefully. 

In any market there is a different demand for sugar at 
different prices. We may define the demand at a given 
price as the amount of sugar which people are willing to 
buy at that price. In the same way the supply at a 
given price is the amount which people are willing to 
sell at that price. If the price of sugar is 8 cents a pound, 
the demand for sugar in a given community at a given time 
may be, let us say, 900 pounds a week. If the price falls 
to 7 cents, the demand would increase, say, to 940 pounds. 



262 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 



If the price falls to 6 cents, the demand would rise, say, to 
looo pounds ; and so on. 

The supply of sugar, we shall suppose, changes in the 
opposite way. At 8 cents it may be iioo pounds; at 7 
cents, 1050 ; at 6 cents, 1000 ; etc. The following table 
shows these figures and others, and constitutes what are 
called " schedules " of demand and supply in relation to 
various prices. 

The schedule of demand is the second column considered 
relatively to the first. It shows the largest quantity which 
will be taken at each given price, or, what amounts to the 
same thing, the highest price at which a given quantity will 
be taken. When the relationship between the two columns 
is expressed in the latter of these two ways, it is more con- 
venient to place the second column first, and the first, second ; 
but their order is immaterial. It is their relation to each 
other which constitutes the demand schedule. 





Price 


SCHEDXJLE OF 


Schedule of 




Demand 


Supply 




.08 


900 


IIOO 




.07 


940 


1050 




.06 


1000 


1000 




■OS 


IIOO 


900 




.04 


1250 


750 



In the same way the relation between the first and third 
columns constitutes the supply schedule. This tells us the 
largest quantities which will be supplied at stated prices, 
or, what amounts to the same thing, the lowest prices at 
which stated quantities will be supplied. 

Running the eye down the table, we see that, although 
the supply at first exceeds the demand, as the price falls 
the demand increases and the supply decreases, until, 
when the price reaches 6 cents, supply and demand are 



Sec. 4] SUPPLY AND DEAIAND 263 

equal. For prices lower than 6 cents we find the reverse 
condition, demand exceeding supply. 

If the foregoing figures represent the demand and supply- 
schedules showing the amounts that buyers are willing to 
take and sellers to give at different prices, it is clear that there 
is only one price that will make supply and demand equal. 
That price is 6 cents, and that is the price that supply and 
demand will finally fix. The price cannot long be above 
6 cents, for then supply would exceed demand, and the 
price would immediately fall. Nor can it be below, for then 
demand would exceed supply, and the price would rise. For 
instance, if the price were 8 cents, the supply (iioo pounds) 
would exceed the demand (900 pounds) by 200 pounds. 
Those wishing to sell this extra amount would then be unable 
to do so except by offering it at a lower price, and their com- 
petition would drive the price down. On the other hand, 
if the price were 4 cents, the demand (1250 pounds) would 
exceed the supply (750 pounds) by 500 pounds, and those 
demanding this extra amount would be unable to get it ex- 
cept by bidding a higher price, and their competition would 
then drive the price up. 

Since, then, the price cannot really be either above or 
below 6 cents, it must be finally fixed at 6 cents. A price 
which thus makes supply and demand equal is said to 
" clear the market," and is called the market price. The 
amounts supplied and demanded at the market price are 
called the amount marketed, i.e., the amount actually bought 
by buyers and sold by sellers. This amount marketed is, 
therefore, at once the market demand and the market supply. 

§ 4. Demand and Supply Curves 

The relations discussed in § 3 above can be seen more 
clearly by means of a diagram. In Figure 18 is repre- 
sented the demand for sugar at different prices. 

The two axes OX and OY are drawn simply for 



264 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 



y 


































12 
II 
10 
9 
8 
7 
6 
5 
A. 
3 
S 




















































































































































D 














y 







































































































































































































































































2C 


JO 


4 


00 


6< 


30 


& 


oo" 


^0 


00 


12 


00 






X 



Fio. 18 (Demand). 



reference, like the equator and the Greenwich meridian in 
a map. The intersection O of the two axes is called the 
" origin." The diagram is a "map" of demand on which 

the "latitude," or 
the distance above 
the line OX, repre- 
sents any price ; 
and the " longi- 
tude," or the dis- 
tance to the right 
of the line OY, 
represents the 
amount demanded 
at that price. Let 
us, for instance, 
represent an as- 
sumed price, say 
8 cents, by 
measuring off the " latitude " Oy from the origin O. 
At this price of 8 cents, the demand, which we have seen 
to be 900 pounds, is represented by the " longitude " yD. 
We have thus located a point D, the " latitude " of which 
represents a particular price (8 cents), and the "longitude" 
of which represents the demand (900 pounds) at that 
price. It will be seen that the " latitude" is simply the 
elevation above the base axis OX, whether we measure 
this " latitude " by the line Oy or by xD. Likewise the 
" longitude " is simply the distance of D to the right of 
the axis OY, whether this distance be measured by yD or 
by Ox. Having found one point, D, the " latitude " and 
" longitude " of which represent, respectively, a price and 
the demand at that price, we may find in like manner 
other points, the " latitudes " and " longitudes " of which 
will represent other particular prices and the demands 
corresponding to those prices. Several such points are 
indicated in Figure 18. It will be seen that the lower in 



Sec. 4] 



SUPPLY AND DEMAND 



265 



the diagram the points, the farther they are to the right. 
This represents the fact that the lower the price, the greater 
the demand. We may suppose the spaces between those 
various points to be filled by other points, all together 
forming what is called the demand curve. 

A demand curve, then, is a curve such that the " lati- 
tude" of any one of its points represents a particular price, 
and the " longitude " of that point the particular demand 
corresponding to that price. Thus a demand curve is a 
graphic picture of 
a demand sched- 
ule. 

In precisely the 
same way we may 
treat supply. In 
Figure 19 let us 
represent any par- 
ticular price, say 
8 cents, by the 
"latitude" Oy, 
and the supply 
corresponding to 
this price (iioo 
pounds) by the 
"longitude " yS. Thus we locate a point S such that its 
" latitude " {Oy or xS) represents a particular price, and 
the "longitude" {yS or Ox) represents the supply at that 
particular price. In Uke manner we may locate other 
points, the " latitudes " of which represent other prices 
and the " longitudes " of which represent the amounts 
which would be supplied at these respective prices. These 
points are so arranged that the higher their " latitude," the 
greater their " longitude." This represents our assumption 
that the higher the price, the greater the supply. The 
curve which these points form is called a supply curve and 
is a graphic picture of a supply schedule. 



T 


































19 


































ri 


































10 
9 
e 
























































































s 










-$ 
































6 
5 

3 


































































































































2 
1 








































^ . 































































S( 


30 


44 


DO 

Fi( 


6< 


DO 

19 


(Su 


30 

ppl 


Id 

y). 


00 


'xz 


op 




^ 


& 



266 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 



In Figure 20 are drawn both the supply and the 
demand curves, the demand curve being DD', and the 
supply curve SS'. We have seen that the demand curve 
shows many different demands at many different prices, 
and that, similarly, the supply curve shows many differ- 
ent supplies at 
many different 
prices; but that 
there is only one 
price at which 
supply and de- 
mand are equal. 
We can see this 
clearly in Figure 
20 ; for there is 
only one point {P) 
in which the two 
curves intersect. 
The " latitude " 
{OP') of the in- 
tersection {P) of the curves DD' and SS' represents the 
market price. The " longitude " of P represents the amount 
marketed, which is at once the supply at that price and the 
demand at that price. The point P may be called the 
market point. 

The market price, OP' , clears the market, and no other 
price will. If, for instance, we take a higher price, such 
as OP" , the supply will be represented by the long line 
P"S", and the demand by the short line P"D", leaving the 
difference between them, or D"S", as the excess of supply 
over demand. The effort of sellers to get rid of this excess 
will drive the price down. Thus the market price cannot 
exceed OP'. In like manner, the market price cannot be 
lower than OP'. If, for instance, it were only OP'", the 
demand would be P"'D"', and the supply only P"'S"', 
leaving an excess of demand over supply of D"'S"', which 



Y 






























































































































5' 


































1 










P" 




















D" 




fs 






























J 












P' 






















(P 
































\ 












P'" 
















lit 


y 






\ 


w, 


















s 




s" 










D'" 


*- 


D" 


























, 















































































































• 


X 



Fig. 20. 



Sec. 4] SUPPLY AND DEMAND 267 

at that price the buyers are unable to obtain. They will 
therefore bid up the price. We see, then, that the only real 
price is OP' . The point P, at which the two curves in- 
tersect, is the only real point, the latitude of which repre- 
sents the market price and the longitude the actual amount 
demanded and sold. All the other points in the two curves 
are hypothetical, representing, not what demand and supply 
actually are, but what they would be at other prices than the 
real market price. 

All demand curves descend to the right. But they de- 
scend at different rates. Those demand curves which are 
steep — descend very rapidly — represent the demand 
schedules of those goods which are called necessities, for 
the rapid descent means that it requires a great fall of 
price to affect demand materially. They have an 'in- 
elastic" demand, which wUl "stretch" but little whatever 
the change in price. We know that the demand for a 
necessity such as salt does not change greatly, even if the 
price changes much. Otherwise expressed, a necessity has 
an '' inelastic" demand which will "stretch" or expand 
but little for a given fall in price. At the other extreme 
are luxuries, the demand curves of which descend very 
slowly, thus interpreting the fact that a slight fall in price 
produces a great expansion in demand. Otherwise ex- 
pressed, a luxury has an "elastic" demand which will 
"stretch" or expand much for a given fall in price. If 
the price of champagne, for instance, is slightly changed, 
the amount of it consumed will be materially affected. 

In the same way supply curves may ascend at different 
rates, the steep ones representing commodities the supply 
of which is "inelastic," that is, cannot expand very much 
for a given increase in price. At the opposite extreme are 
the supply curves which ascend very slowly, being those of 
commodities, the supply of which is very "elastic" — can 
be greatly increased by a given increase in price. 

Most of the articles produced in extractive industries 



268 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 

such as agriculture or mining are of the rapidly ascending 
type, while manufactured articles often illustrate the 
slightly ascending type. It requires a great increase in the 
price of coal to affect materially the output of coal mines, 
but it requires only a slight rise in price of manufactured 
products to lead to an enormous increase in the output. 

§ 5. Shifting of Demand or Supply 

Having represented supply and demand by curves, we 
are now in a position to understand more clearly what is 
meant by " increase of demand " or " increase of supply." 
These phrases are often used loosely, without realization 
that they are ambiguous. Sometimes we hear it said 
that " demand has increased " when the speaker merely 
means that demand has increased as a consequence of 
a fall in the market price; that is, the demand at a new 
and lower market price is greater than the demand at 
the old >and higher market price, although the demand 
at this old price remains unchanged. Thus if the price 
of sugar falls from 8 cents to 5 cents per pound, the 
demand at the new market price, 5 cents, will exceed 
the old demand at the old market price, 8 cents, al- 
though the amounts demanded at 8 cents may remain 
unaltered and the amount demanded at 5 cents may 
remain unaltered. In this case the demand schedule 
remains unchanged. Only the particular demand in that 
schedule which corresponds to the market price is shifted 
downward in the second column (see §3). 

Again, and more properly, we hear it said that 
" demand has increased " when the speaker means that the 
demand at a specified price has increased ; as, for instance, 
that more sugar is demanded at 8 cents than formerly, 
and more, likewise, at 5 cents, or any other price ; that in 
short the demand schedule has changed through the in- 
crease of the figures in the second column. 



Sec. s] 



SUPPLY AND DEMAND 



269 




The two meanings Y 
which have been distin- 
guished may' be desig- 
nated respectively as "in- ; 
crease of the market \ 
demand " and as " increase 
of the demand schedule.''^ 
We have spoken only of 

changes in demand. But 

the same distinctions apply, 
of course, to two meanings ^^''- " (demand). 

of the phrase "increase of supply," one, an increase in 
Y the market supply, and the 

other, an increase in the 
supply schedule. 

We may see clearly the 
distinction between these 
two meanings of the phrase 
" increase of demand " and 
avoid their confusion if we 
express them by means of 
"~y diagrams. Increase of de- 
mand may mean a mere 
shifting of the market point from one position A to another 
position B, farther to the 




Fig. 22 (Demand). 



right on the same demand 
curve (Fig. 21), or it may 
mean a shifting of the entire 
demand cwrz;e from the posi- 
tion A to the position B, 
farther to the right (Fig. 22) . 
Both of these meanings 
are admissible, but they are 
entirely distinct. In the 
same way, "increase of 
supply " may mean one of 



Y 




Fig. 23 (Supply). 



27© 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 








Fig. 24 (Supply). 



two things, either a shifting of the market point A to another 

position B, farther to the right, on the same supply curve 

(Fig. 23), or a shifting of 
I the entire supply curve from 

the position A to the posi- 
tion B farther to the right, 
as in Figure 24, We see, 
therefore, that an " in- 
crease of supply" or of 
demand may mean either 
a change of the market 
point on the same curve 
or a change of the curve 
itself. 

It will be seen that an 

increase of demand in the market sense is nothing else than 

an increase of supply in the schedule sense ; for we have 

already made it clear that there is only one point which is 

the intersection of the two 

curves, and that this point ^ 

cannot be shifted to the right 

from ^ to 5 on the demand 

curve unless the whole sup- 
ply curve has shifted so as 

to change the intersection. 

Such a shifting is seen in 

Figure 25. Here the demand 

has increased in the market 

sense, having changed from -^ 

the longitude of A to the -pia. 25. 

longitude of B on the same 

demand curve ; but this increased demand comes about 

only because the supply has increased in the schedule sense, 

having shifted from the position of the unbroken supply 

curve to the position of the dotted curve. 

To express these changes in terms of the schedules of 




K 



Sec. s] 



SUPPLY AND DEMAND 



271 








§3, let us suppose that the supply schedule is changed by 
the addition of 200 pounds of sugar to each quantity 
given in the third column. It is evident that the market 
price will fall from six cents (at which supply and demand 
were each 1000) to five cents (at which supply and de- 
mand are each 11 00). Thus the demand at the market 
price has increased from 
1000 to 1 100 as a con- 
sequence of the increases 
in the supply schedule. 

Again, to say that sup- 
ply has increased in the 
market sense is the same 
thing as to say that the 
demand has increased in 
the schedule sense. This 
is shown in Figure 26, 
where the market point 
A on the supply curve 
has shifted to B on the same curve, because the demand 
curve had shifted from the unbroken to the dotted posi- 
tion. The same result can, of course, be expressed in 
terms of a change in the demand schedule of § 3 . 

We should, therefore, be careful to know, when we speak 
of a change in demand or supply, whether we mean that the 
change is in the market sense or in the schedule sense. It 
seems odd at first to think that an increase of demand in 
one sense is really an increase of supply in another sense, 
and vice versa. Because of this ambiguity, when one 
person speaks of an increase of supply, it means the same 
thing as when another speaks of an increase of demand. 

To illustrate the two meanings, let us suppose that the 
demand considered is the demand for automobiles, and 
that, given the same price, people would demand auto- 
mobiles now no more and no less than they did a few years 
ago, but that the conditions of the supply have changed, so 



Fig. 26. 



272 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XV 

that now more automobiles can be supplied for the same 
price. That would mean that the supply curve had 
shifted to the right, so that its point of intersection with 
the same demand curve has also shifted to the right 
(Fig. 25). Therefore two things have happened on the 
demand side. The market price has fallen, and as a con- 
sequence of that fall of price the number of automobiles 
demanded has increased. The demand at the market price 
has increased, but the demand schedule has not changed 
at all. People are just as willing as before to take an 
automobile at any given price, but they are willing to 
take more automobiles at present low prices than at 
former high prices. There have been no changes in the 
conditions of demand, i.e., the demand schedule. What 
have changed are the conditions of supply, i.e., the supply 
schedule. 

On the other hand, let us take as our illustration works of 
art. In the past few years there has been a great change 
in the attitude of Americans toward works of art. Of these 
we are much more appreciative than we used to be, and are 
willing to pay more, for instance, for a fine painting than 
previously. Thus, for works of art the demand schedule 
has sliifted; the demand for works of art has increased 
in the schedule sense (Fig. 26). Consequently, the supply 
has increased in the market sense; namely, on account 
of the greater demand the price has risen, and therefore 
owners and makers of works of art have offered more 
for sale. 

Thus increase of demand in the schedule sense brings 
about increase of supply in the market sense, and vice 
versa. An increase in the supply of automobiles in the 
schedule sense brought about an increase in the demand 
for automobiles in the market sense, while an increase in 
the demand for works of art in the schedule sense brought 
about an increase in the supply of works of art in the 
market sense. In either case the original change is in a 



Sec. s] supply AND DEMAND . 273 

schedule or curve. There can evidently be no change of 
points of intersection except by a change in at least one of 
the two curves. • Hereafter we shall use the phrases " in- 
crease of supply " or " increase of demand " only in the 
sense of shifting to the right the supply or demand curve; in 
other words, of increasing the figures of demand or supply 
in the demand or supply schedules. 

When we shift demand or supply curves, the effect on 
the intersection, i.e., on the market price, and the amount 
marketed, will, as is evident from the figures, depend greatly 
on the character of the curves ; whether, for instance, one 
or both of them ascend rapidly or slowly. It will be in- 
structive for the student to draw on paper various pairs of 
intersecting curves, making one or both nearly horizontal, 
and again one or both nearly vertical, and to observe the 
various effects then obtained, first, by shifting the demand 
curve a given distance to the right or left, and second, by 
shifting the supply curve a given distance to the right or 
left.^ In actual fact, demand and supply curves are con- 
stantly shifting, with the result that their point of inter- 
section is constantly shifting, sometimes to the right, 
sometimes to the left, sometimes up and sometimes down. 
Consequently the market price and the amount marketed 
are changing from time to time. 

The causes which shift the curves are innumerable. 
Changes in taste or fashion will affect demand curves, while 
changes in methods of production will affect the supply 
curves. For instance, fashion and outdoor sports, includ- 
ing motoring, have increased the demand for fur coats, 
and have, therefore, raised their price; while improved 
machinery has increased the supply of shoes and has 
consequently lowered their price. 

^ Observe that when the demand curve is shifted, the change in price 
involved depends upon the steepness of the supply curve ; and, vice versa, 
that when the supply curve is shifted, the change in price involved depends 
upon the steepness of the demand curve. 

T 



274 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 



As to the variable point of intersection, we are more in- 
terested in its latitude than in its longitude, for the latitude 
represents the market price. This market price will evi- 
dently rise with a rise in either curve, and fall with a fall in 
either curve. It will also rise with a shifting of the demand 
curve to the right, or with a shifting of the supply curve 
to the left ; and will fall with a shifting of the demand curve 
to the left, or of the supply curve to the right. In fact, 
by a leftward change in the demand curve or a rightward 
change in the supply curve, the price may fall to zero. A 
standard example of such a case is furnished by the air we 
breathe, the supply of which is so much greater than 
the demand that it bears no price. The same is often true 

of water and of 
land of inferior 
qualities. There 
are millions of 
acres of land which 
may be had for 
practically nothing 
(a fact of much 
importance to be 
emphasized in a 
future chapter). 

One cause of 
shifting demand 
and supply curves 
mentioned in a 
general way at the 
beginning of this 
chapter we wish especially to emphasize. This cause is a 
change in the general purchasing power of money. Let us 
suppose that we change our monetary unit so that what is 
now fifty cents should be called a dollar. This would mean 
that the purchasing power of a dollar had been cut in two, 
or that the level of prices had been doubled. We ought, 



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X 



Fig. 27. 



Sec. s] 



SUPPLY AND DEMAND 



275 



therefore, to find that the demand and supply of sugar will 
have been affected so as to double its price — the latitude of 
the point of intersection — and this will be, in fact, the 
result, unless prevented by some interfering cause. As soon 
as the half-dollar becomes a dollar, the price in " dollars " 
at which any given amount of sugar, such as Ox (in Fig. 27), 
is demanded, will evidently be doubled, becoming xB, which is 
twice xA . If previously people were willing to take Ox at one 
price, they are now wilhng to take it at double that price, be- 
cause this double price means in purchasing power exactly the 
same thing as the original price. And, in fact, all points in 
the demand curve will be shifted to be twice as high as before. 

In the same way and for the same reasons, those who 
have sugar to sell 
will require twice 
as high a price as 
before for a given 
amount; because, 
otherwise, they 
would not get the 
same purchasing 
power as before in 
return. Thus, as 
indicated in Figure 
28, each point, 
such as ^, in the 
supply curve, will 
be shifted to twice 
as high an elevation 
above the base, OX. 

When the two curves thus shifted are drawn on the same axes 
(see Fig. 29), it is evident that the new point of intersection, 
B, will be vertically over the old point of intersection, A. 

The market price of sugar is therefore doubled, though 
the amount marketed is unchanged. Simply the doubling 
of the general price level carries with it a doubUng in the 



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Fig. 



276 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XV 



price of sugar. While the supply and demand curves for 
sugar may change for many other reasons than the dou- 
bling in general price level, so far as this cause, taken by 
itself, is concerned, its effect on prices is to double them. 
Our analysis of demand and supply curves then brings us 
back to the fact already stated, that the price of any par- 
ticular good, like sugar, depends partly on the general 
level of prices, or the purchasing power of money. 

We can now see more clearly than before the shallowness 
of the idea that the supply and demand of each individ- 
ual commodity fix its price independently of other com- 
modities. According to this view, the general price level 
is regarded as the effect of innumerable individual pairs of 
supply and demand curves, each pair being supposed to 
completely determine some one price. The opposite is the 
truth. The general price level is not the result of the supply 
and demand of sugar in relation to money, but is itself one 
of the causes affecting the supply and demand of sugar in 

relation to money ; 
for we have seen 
(Figs. 27, 28 and 
29, and discussion) 
that, as the price 
level rises or falls, 
the price of sugar 
rises and falls cor- 
respondingly. 

We end this 
chapter, therefore, 
with the state- 
ment with which 
we began ; name- 
ly, that it is im- 
Pjg portant to distin- 

guish between the 
influences determining the general price level and the 



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X 



Sec. 5] SUPPLY AND DEMAND 277 

influences determining an individual price. The price 
level is determined by a comparatively simple mechanism, 
that of the equation of exchange. It is the result of the 
quantity of money and deposits, the velocities of their cir- 
culation, and the volume of trade. The general price 
level then helps to fix individual prices, although not in- 
terfering with relative variations among them, just as the 
general level of the ocean helps fix the level of individual 
waves and troughs without interfering with variations among 
them. The tides determine whether a wave shall be as 
a whole high or low, and so the general level of prices, while 
it does not fully fix the price of sugar, determines whether 
it shall be in general high or low. A rise in the general price 
level is one of the many causes raising the demand and supply 
curves of sugar ; and, reversely, a fall in that level is a cause 
lowering those curves. 



CHAPTER XVI 

THE INTLUENCES BEHIND DEMAND 

§ I. Individual Demand Schedules and Curves 

We have seen that the market price of any particular 
good is that price in the demand and supply schedules which 
will just " clear the market." By this phrase is meant, 
of course, that the price will make supply and demand 
equal. Both the market price and the quantity marketed 
are determined by the intersection of the supply and de- 
mand curves. We have therefore explained how the market 
price (as well as quantity marketed) of any particular good 
is fixed by supply and demand. 

But supply and demand are not the ultimate influences 
determining prices. They are only the proximate influ- 
ences. Beneath and behind them lie influences more re- 
mote and more fundamental. In this chapter we shall 
trace back these influences so far as they have to do with 
the demand side of the market. We shall find (i) that 
the demand schedule explained in the last chapter is formed 
out of a large number of individual demaiid schedules, and 
(2) that each individual demand schedule is in turn formed 
out of two " desirability " schedules. 

In the first place, then, what we have called the demand 
schedule is only an aggregate demand schedule. It is for 
the whole market, and resolvable into constituent demand 
schedules, one for each particular person in the market. 
The total demand at any price is merely the sum of the indi- 
vidual demands at that price. For instance, let the follow- 
ing table represent the demand schedules for coal of two in- 

278 



Sec. i] 



THE INFLUENCES BEHIND DEMAND 



279 



dividuals distinguished as Individual No. I and Individual 
No. II, at prices of from $12 to $2 per ton : — 



Demand Schedules 



Price 


No. I 
(a) 


No. II 


Total 
(a + J) 


$12 


I 





I 




10 


2 





2 




8 


3 





3 




6 


4 


I 


5 




S 


5 


2 


7 




4 


6 


3 


9 




3 


7 


4 


II 




2 


8 


6 


14 





The table tells us that at a price of $12 a ton Individual No. 
I will take only one ton, and Individual No. II will not 
take any ; that at 
a price of $6 a 
ton Individual 
No. I will take 
four tons, and In- 
dividual No. II 
will take one ton ; 
and so on. The 
last column gives 
the sum of the 
demands of these 
two individuals. 
If we should ex- 
tend such a table 
to include the de- 
mands of all the 
individuals in the 
community, we would obtain in the last column the total 
demand in the community. The total demand schedule 
is thus merely the sum of the individual demand schedules 




a CJ 4 5 6 7 6 9 10 H Ja 13 14 

FiG. 30. 



28o ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 



found by adding together all the individual amounts de- 
manded at any given price. Behind the total demand 
schedule, therefore, are a number of constituent demand 
schedules. 

The same relation, of course, holds between total and 
individual demand curves. In Figure 30 let the curve didi 
represent the demand curve for Individual No. I, and d^di' 
the demand curve for Individual No. II. At a given 
price, represented by the vertical distance or " latitude," 
Oy, the demands of these two individuals are represented 

respectively by the horizon- 
tal distances or "longi- 
tudes," ydi and yd^. The 
sum of these two demands 
is represented by the longer 
horizontal distance, yD. 
Thus we add the longitudes 
of the two individual de- 
mand curves together to get 
the longitude of the com- 
bined curve DD'. If, in- 
stead of two individual de- 
mand curves, we should have 
all the demand curves in the market, and should add together 
the longitudes corresponding to given latitudes, i.e., the de- 
mands corresponding to given prices, we should thereby 
obtain the total demand curve of the market. 

We may pause here to note the fact that, ordinarily, any 
one individual plays so small a part in the demand for any 
commodity that he regards the price as beyond the influence 
of any act of his. He finds this price ready made in the 
market and adjusts his demand to it. To him the price is 
a fixed fact and entirely beyond his control, while his de- 
mand, the quantity he chooses to take at that price, is 
the only thing which he can adjust. It is of course true 
that each individual, however insignificant his demand, 




Fig. 31. 



Sec. 2] THE INFLUENCES BEHIND DEMAND 28 1 

has theoretically an influence upon the general price, but 
the influence is so small as to be practically negligible. While, 
for the market as a whole, price is effect and not cause, yet 
for the individual it is cause rather than effect. 

To show more clearly these relations to the individual 
and to the total, we have drawn in Figure 31 an individual 
demand curve dd' , the total demand curve DD\ and the 
total supply curve SS' . The intersection of the last two 
determines the market price P X (or OP' , or px) ; and this 
price determines /or the individual the amount, P'p (or Ox), 
which he will take at that price. 

§ 2, Desirability 

We have now found that back of the demand curve or 
schedule in any market lie the individual demand curves 
or schedules of all the people who compose that market. 
The next step is to find what causes lie back of the indi- 
vidual demand curves or schedules. Taking, for instance, 
the demand curve of Individual No. I, we may ask : What 
are the conditions which determine its shape and size? 
The answer is that it depends upon the desires or " wants " 
of Individual No. I. It is true that a man may have a 
strong desire for something without having any demand for 
it in the economic sense. But this is simply because he 
desires still more the money he would have to spend for it. 
Every purchaser of goods balances two desires, the desire 
for the goods and the desire for the money they would cost. 
On the relative strength of these desires depends the price 
he is willing to pay. We have, therefore, to investigate 
these two desires, the one for goods, the other for money. 
We shall begin with the desire for the goods. 

Desire for goods implies desirability in those goods. The 
term " desirability " is synonymous with what is usually 
called " utility " in textbooks. " Desirability " is preferred 
here as a better term to express the idea intended. If there 



282 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

exists a keen desire to purchase a certain piece of land, we 
say that the land is especially desirable or has great desir- 
ability. Likewise precious stones have great desirability 
to many people. Tobacco has great desirability to a smoker ; 
silks and satins to ladies of fashion ; books to scholars ; and 
so on. The concept " desirabihty " is so important that it 
ought to be defined with great care. The desirability of 
any particular good, at any particular time, to any partic- 
ular individual, under any particular conditions, is the 
strength or intensity of his desire for that good at that time 
and under those conditions. The desirability of any good is 
one of the most important factors in determining its price. 
The connection, however, between desirability and price 
was for a long time overlooked because of the puzzling fact 
that many of the most desirable articles are the cheapest, and 
many of the least desirable are the dearest. Thus water is 
so desirable as to be indispensable ; yet there are few things 
which are cheaper. On the other hand, jewelry, which could 
easily be dispensed with, bears high prices. This paradox, 
however, is easily explained. While it is true that water as 
a whole is very desirable, the desirability of any one quart 
of water, to be added to or taken away from the whole 
amount, is negligible. This one quart could make little dif- 
ference to anybody because there are so many other quarts 
which could take its place. Were any one quart of water 
indispensable, water would bear a high price. On the other 
hand, while all the jewels of the world could be more easily 
dispensed with than all the water, yet any one jewel is 
more desired than any one quart of water. The desira- 
bility of any one diamond, to be added to or taken away 
from the few which the owner possesses, is very great. 
Jewels are rare, and one jewel more or less may make a 
great deal of difference. It is the desirability of any one 
unit of water or of jewelry which influences its price and 
not the desirability of all the water in our possession or of 
all the jewelry. 



Sec. 3] THE INFLUENCES BEHIND DEMAND 283 

We see, then, that the desirability of water or of any 
other sort of good may mean either (i) the desirability of 
the whole or (2) the desirability of one unit more or less. 
The desirability of the whole is called the total desirability ; 
the desirability of one unit more or less is called the mar- 
ginal desirability. The marginal desirability of any good is 
the desirability of one unit more or less of it. In economic 
science we have more to do with marginal than with total 
desirability, and it is therefore important that the concept 
of marginal desirabiHty should be thoroughly understood. 

§ 3. Illustration 

To illustrate in detail the distinction between total and 
marginal desirability, let us suppose a person wishing to fur- 
nish his house with chairs. As presumably he does not wish 
to sit or compel his friends to sit on the floor, it is extremely 
desirable that he should have some chairs ; but each succes- 
sive chair that he introduces will lessen the need for more. 
One chair is so highly desirable as to be almost indispen- 
sable. It provides a seat for at least one person. A second 
chair, though not quite so indispensable as the fiist, is also 
extremely desirable, as it is Hkely that he will often wish 
seating capacity for at least two. A third chair, though 
less urgently needed than the second, will be highly desir- 
able ; and so on — each successive chair having a lower 
desirability than the preceding. The number of chairs 
which he will buy will depend, among other things, upon 
their price. To fix our ideas, let us suppose that he decides 
to buy ten. Then the tenth chair is called the marginal 
chair of the ten, and its desirability is called the narginal 
desirabihty of the ten. It is this tenth or marginal chair 
which gives him the most concern when he attempts to 
decide how many to buy. He has no difficulty, for instance, 
in deciding that he does not want thirty or forty chairs. ; the 
question which requires careful consideration in his mind 



284 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

is whether he shall stop buying at the tenth chair or at a 
slightly earlier or later point. He will consider carefully 
what difference it will make whether he has nine chairs or 
ten, or what difference it will make whether he has ten or 
eleven. If he decides on ten rather than nine, it is because 
he thinks the tenth chair will make enough difference to him 
to he worth the price he pays, and if he decides against the 
eleventh chair, it will be because he thinks this will not make 
enough difference to compensate him for the price. For 
instance, let us suppose that the price of the chairs is $10 
each ; then the fact that he decides to take the tenth chair 
shows that this tenth chair has at least $10 worth of desira- 
bility, while the fact that he decides against the eleventh 
chair shows that this eleventh chair does not have as much 
as $10 worth of desirability. Practically money is used in 
just this way to measure the comparative desirabilities of 
various goods. 

As has been stated, the last or tenth chair bought is called 
the marginal chair of the ten, and the desirability of this 
last or tenth chair is called the marginal desirabihty of the 
ten chairs. The total desirability, on the other hand, of the 
ten chairs is evidently quite another matter. This is not 
10 X" $10. It is the sum of the desirabilities of the first 
chair, second, third, etc., considered, as above, in succession 
up to the tenth. The householder will not ordinarily be 
as definitely aware of total desirability as he is of marginal 
desirabihty. As we have seen, he will, in order to decide 
how many chairs to buy, have to give careful attention 
to the desirabihty of the tenth chair; it is so easy to 
decide upon the first few chairs that he will not ordinarily 
stop to reckcn exactly how desirable the ten chairs as a 
whole may be. Should he wish to reckon this desirabilit}^, 
he Wv)uld do so by thinking how much difference it makes 
tc fiim whether he has ten chairs or none at all. For 
insta.nce, he might think that to have ten chairs rather 
than, none at all is worth about $150 to him. Then $150 



Sec. 3] THE INFLUENCES BEHIND DEMAND 285 

would measure the total desirability of the ten chairs, while 
the marginal desirability, that is, the desirability of the last 
or tenth chair, is only about $10. From what has been said 
it will be evident that the total desirability is of only theo- 
retical importance, while marginal desirability is of great 
practical importance. It is of little practical importance to 
any purchaser to know how much is the total desirability of 
the chairs he owns ; namely, how great is the difference in 
comfort and convenience between having the number of 
chairs which he actually does have and having none at all. 
He finds it difficult to imagine how it would seem to have 
none at all. Such a condition can be considered only hypo- 
thetically. It never enters into his calculations as a practi- 
cal possibility. 

On the other hand, marginal desirability enters daily 
into practical life. The question which every purchaser of 
goods asks himself is where to stop — where to draw the line 
or margin beyond which he will not buy. He has to fix a 
margin in every purchase, and in fixing it he has to settle 
the question whether one unit more or less is or is not as 
desirable as the money which he will have to pay for it. 
In other words, with the desirability of this unit, he has to 
compare the desirability of the money which it will cost. 
He can only solve the question of how much to buy by 
weighing carefully in his mind the desirability of ^he last 
few units, balancing each against the desirability of the 
money which it costs. At last he decides to limit his 
purchase at a certain point beyond which the next unit 
would not be worth to him what it would cast. The pre- 
ceding unit — the last which he decides to buy — is ad- 
judged as barely worth its cost, affording, ^perhaps, a slig 
advantage or surplus desirabihty. Oir the unit next p 
ceding, the advantage or surplus desirabiility is greater 
so on l^^ckward ; but the further back we g-'o the less 
fully are the desirabilities weighed. 



286 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 



§ 4. Some Remarks on Desirability 

The total quantity of goods whose marginal desirability 
is under consideration may be any specified quantity of 
goods whatever. It may be a specified quantity of goods 
now existing, or a specified quantity of goods in the future, 
or a specified flow of goods through a period of time. For 
instance, by the marginal desirability of coal to an individ- 
ual may be meant the marginal desirability of the particular 
stock of coal in his bin at the present moment. If this stock 
consists of fifteen tons, its marginal desirability is the 
desirability of the fifteenth ton, or the difference to him 
between the desirabiHty of having fifteen and of having 
fourteen tons. Again, if a person is consuming in his house- 
hold fifteen tons of coal a year, its marginal desirability 
at any time is the desirability of the fifteenth ton, or the 
sacrifice which, in his estimation at that time, would be 
occasioned were he to reduce his yearly consumption from 
fifteen tons to fourteen. A stock of fifteen tons and a con- 
sumption of fifteen tons a year are evidently quite distinct. 
It is, therefore, necessary in each case to specify the particu- 
lar quantity of goods referred to, whether it be a stock in 
the present or a stock in the future or a flow through a 
period of time. 

Undesirability is the opposite of desirability. Often we 
may express the very same fact by either word. For 
instiince, it does not matter whether we speak of the 
desirability of keeping money, or the undesirability of 
losing it. 

3ne of the m\ost important general facts in regard to 

ginal desirabilitv is that an increase in the quantity of 

^. whose mar-'ginal d-^sirability is under consideration 

s in a decr^ease in the mtiiginal desirabil^'tv. This we 

noted i'ii the case of the chairs. Each unit in addition 

desirable than the preceding unit. 



Sec. s] the INFLUENCES BEHIND DEMAND 287 

Marginal desirability is, as we have seen, often expressed 
as the desirability of the " last " unit. But this word 
" last " is used metaphorically and not in any literal sense 
of sequence in time. All of the supposed ten chairs may 
be bought at the very same instant. The desirability of the 
tenth chair simply means the difference in desirability be- 
tween having ten chairs and having only nine. Any one 
of the ten chairs may be considered as the tenth. 

A special and important instance of marginal desira- 
bility is the marginal desirability of money. The marginal 
desirability of money at any particular time, to any par- 
ticular individual, under any particular conditions, has the 
same sort of meaning as the marginal desirabihty of any 
other good. It means, therefore, the strength or intensity 
of a man's desire for an additional dollar, or, what amounts 
to the same thing, his reluctance to part with it. Briefly, 
the marginal desirability of money to him is the desira- 
bility of a dollar to him. Whenever he thinks of making 
a purchase, this desire comes into play, and the question 
of whether or not to buy is, as implied in the preceding 
discussion, determined by his judgment as to whether or 
not the marginal desirability of the goods exceeds the mar- 
ginal desirabihty of money multipHed by the price in money 
required to secure those goods. 

§ 5. Individual Demands derived from Marginal 
Desirabilities 

It is on such comparison of the marginal desirabilities 
of goods and money that the demand curve of each individ- 
ual depends. We shall now illustrate in detail how demand 
depends on desirability by taking the desires and demand 
of a given individual (whom we shall call No. I) for a given 
good (such as coal). As in the case of the chairs, the price 
Individual No. I is willing to pay is simply the ratio between 
two marginal desirabilities, that of coal and that of money. 



288 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

We are to find how each individual demand schedule, as 
given in § I, depends upon two antecedent schedules of 
" desirability." If Individual No. I thinks that one ton of 
coal is a dozen times as desirable to him as a dollar, he 
will evidently be wiUing to pay any price up to $12 for that 
ton. If the price is over $12, he will not buy even a ton 
of coal. If it is just $12, he is willing to buy just one ton. 
A second ton will be worth less, in his estimation, being, let 
us say, only ten times as desirable as a dollar. He will 
then be willing to pay up to $10 for this second ton. If, 
then, the price is $10, he will buy up to two tons ; for at 
that price it will evidently be more than worth his while 
to buy the first ton and just worth his while to buy the 
second. If the desirability of a third ton is eight times 
the desirability of a dollar, he will be willing to pay up to 
$ 8 per ton for three tons ; for at that price the first and 
second tons are more desirable than the money, and the 
third, just as desirable. If the desirability of the fourth 
ton is six times that of a dollar, he is willing to pay a 
price up to $ 6 per ton for four tons.^ 

^ He will stop buying at that point at which the last unit bought has 
slightly more desirability than the money it costs, and the next unit (left 
unbought) has slightly less desirability than the money it costs. Thus, if 
the price of coal is $5.50 per ton, he will buy four tons because the fourth 
ton is sHghtly more desirable than $5.50 (being, according to the figures 
supposed above, as desirable as $6.00) while the fifth ton is slightly less 
desirable than $5.50 (being only as desirable as I5.00). In the case of 
most purchases, the desirability of the last of the units bought and that 
of the first of those unbought differ so slightly that we may call either of 
them the marginal desirability. That is why we have spoken of marginal 
desirability as the desirability of one unit more or less. Strictly speaking, 
however, the margin Hes between the last of the units bought and the first 
of those unbought, and the marginal desirabiHty may be called a mean of 
the desirabilities of these two units rather than the desirability of either. 
In some cases the desirability of the last unit bought and the next unit 
(first unbought) are widely different. This is true when the units are large 
and are not subdivisible into smaller units. For instance, pianos are large 
units and not subdivisible. One cannot buy one and a half pianos, but 
must choose between buying one and buying two. Only one piano is 
usually bought by a family. A second piano would have little or no desira- 



Sec. s] 



THE INFLUENCES BEHIND DEMAND 



289 



In each case the highest price he is willing to pay for a given 
quantity is measured by the ratio of the desirability of the last 
ton to the desirability of a dollar. The consequent deriva- 
tion of prices from desirabilities is summarized in the fol- 
lowing table : — 





Tons Purchased 


Desirability of 
Last Ton 
Purchased 


Desirability of 
A Dollar 


Price per Ton the 

Customer would 
BE willing to Pay 




(a) 


ib) 


(a-^b) 


I 


12 




I12 ( 


2 


10 




10 


3 


8 




8 


4 


6 




6 


5 


5 




5 


6 


4 




4 



As indicated, the last column is found by taking the ratio 
of the figures in the second to those in the third ; that is, 
dividing (a) by (b). As there are no standard units of 
desirability, it will not matter what unit we select. In the 
table, for simplicity of division, we have taken as our unit 
for measuring desirability the marginal desirability of money 
to Individual No. I himself. We thus derive the individ- 
ual's demand schedule from his schedule of desirabilities. 
The resulting demand schedule is the fourth column con- 
sidered with respect to the first column. It tells us the 
highest prices (column 4) Individual No. I is willing to 
pay for stated quantities of coal (column i), or, what 
amounts to the same thing, the largest quantities of coal 
he is willing to take at stated prices. As shown in the 



bility. In this case the difference between the desirability of the piano 
which is bought and that of the next which is not bought, is very great. 
The family might be willing to give $1000, if need be, to get one piano 
but only $ 10 to get a second, 
u 



290 



ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 



preceding chapter, it does not matter which way the rela- 
tion is expressed. 

In the preceding table the numbers expressing desirabil- 
ities of coal and those expressing price are the same, be- 
cause we arbitrarily represented the desirability of a dollar 
by " I " ; i.e., we took the marginal desirability of money as 
our unit of desirability. In this case we may say that the 
marginal desirability of any point in the table is measured 
numerically by the money the individual is willing to pay 
for the marginal unit at that point. But imagine another 
individual (No. II) — an individual who has precisely the 
same intensities of desire as No. I for coal, but who, on 
account of relative poverty, prizes each dollar twice as 
much as does Individual No. I. In comparing the two 
men, we shall have to use the same unit of desirability, 
viz., the marginal desirability of money to Individual No. I. 
For Individual No. II the desirability of money is, there- 
fore, two such units. The result is the following table for 
Individual No. II : — 





Tons Purchased 


Desirability of 

Each Successive 

Ton 


Desirability of 
A Dollar 


Price per Ton the 
Customer would 

BE WILLING TO PaY 




(a) 


(.b) 


ia^b) 


I 


12 


2 


$6 


2 


10 


2 


5 


3 


8 


2 


4 


4 


6 


2 


3 


5 


5 


2 


2.50 


6 


4 


2 


2 



The first ton has a desirability of 1 2 units Just as did the 
first ton for Individual No. I, but the desirability of a dollar 
to Individual No. II is twice as great as the desirability of 
a dollar to Individual No. I. Hence the first ton, instead 
of being twelve times as desirable as a dollar, is only six 



Sec. s] the influences BEHIND DEMAND 291 

times as desirable. Therefore he is willing to pay only up 
to $6 for it. Just as in the case of Individual No. I, the 
prices in the last column are found by dividing the figures 
in the second column by those in the third. In this case, 
however, the figures in the last column are not identical with 
those in the second column, but are only half as great. 
And in general the higher the marginal desirability of money, 
the lower the schedule of prices which buyers are willing to 
give. 

We see, then, that the two individuals, though they have 
precisely the same intensities of desire for coal, have very 
different demands for coal. If the price of coal is $5 a ton, 
Individual No. I will buy up to the fifth ton ; for when he 
reaches the fifth ton, and not before, the marginal desirability 
of coal (5) to him will be just five times that of a dollar (i). 
But at this same price of $5, Individual No. II will buy only 
up to two tons ; for in his case the second ton is the point 
at which the marginal desirability of coal (10) is five times 
the marginal desirability of a dollar (2). This contrast 
interprets the fact that the poor " cannot afford " to buy 
as much as the rich. The poor, like Individual No. II, 
have a relatively high marginal desirability of money. 

It is easy to express these same relations by curves. A 
demand curve is, as we know, merely a graphic picture 
of a demand schedule. We may likewise draw desirability 
curves as graphic pictures of desirability schedules. And 
just as the demand schedule is derived by simple division 
from desirability schedules, so is the demand curve derived 
by simple division from desirability curves. 

In Figure 32 the curve dd' is the desirability curve of coal 
for Individual No. I ; that is, it represents the desirability 
to him of each successive ton of coal as given in the pre- 
ceding table. Thus the latitude or height (12) oi d repre- 
sents the desirabihty of the first ton. The height (10) of 
the next point to the right represents the desirability of 
the second ton ; and so on to d', the height of which (5) 



292 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XVI 



d' 



S 



Fig. 32. 



represents the desirability of the fifth ton. The desira- 
bility of the fifth ton is, as we know, the " marginal desira- 
_ ^ bihty " of five tons, the 

desirability of the fourth, 
the marginal desirabihty of 
four tons, etc. That is, the 
latitude or height of each 
of the points from d to d' 
represents the marginal de- 
sirabihty of the amount of 
coal corresponding to the 
longitude of that point. 
The heights of the points 
which form a horizontal 
row one unit above the 
base represent the marginal 
desirability of money. 
From the heightsof these two sets of points — the upper ones 
representing the marginal desirability of coal and the lower 
ones representing the marginal desirability of money — 
by simple division of the numbers indicated, we derive the 
heights of the set of points constituting the demand curve 
for Individual No. I. As the divisor is in this case unity, 
the demand curve so derived will coincide with the curve 
dd' . Hence dd' will serve not only as the desirability curve 
for coal for Individual No. I, but also as the demand 
curve for Individual No. I. 

Figure 33 represents the corresponding curves for In- 
dividual No. II, for whom, by hj^othesis, there are precisely 
the same marginal desirabilities of coal, but for whom the 
marginal desirability of money is twice as great. The 
upper points, r to r' , represent the marginal desirability of 
coal, and are at the same heights as the upper points d to 
d' in Figure 32. The lower points in Figure 33, however, 
are now two units high instead of one. Hence, when we 
divide the numbers 12, etc., for rr' by the number 2, we 



Sec. s] 



THE INFLUENCES BEHIND DEMAND 



293 



shall get as our demand curve a curve dd' , which, unlike 
the demand curve for Individual No, I, will not coincide 
with rr' , but will be everywhere only half as high. 

We see, then, how to derive an individual demand sched- 
ule (or curve) by dividing, so to speak, one desirability 
schedule (or curve) by an- 
other. The resulting de- 
mand schedule (or curve) of 
coal will coincide with the 
schedule (or curve) of mar- 
ginal desirability of coal if 
the marginal desirability of 
money be taken as unity. 
Otherwise the demand 
schedule (or curve) will have 
its figures all standing in a 
given ratio to those of the 
schedule (or curve) of mar- 
ginal desirability of coal. 
In either case the demand 

curve is, or is equal to, a desirability curve translated into 
terms of money. 

This is all true on the assumption that the marginal 
desirability of money for each individual remains constant, 
as represented in our tables or curves, being always unity for 
Individual No. I and always 2 for Individual No. II. In 
other words, we have assumed that the marginal desirability 
of money is not appreciably affected by a large or small pur- 
chase of coal. Of course, a purchase might be made so large 
and at so high a price that the marginal desirability of money 
would be appreciably affected. Theoretically, the marginal 
desirability of money increases with every expenditure; 
the less money there is left, the more precious it becomes. 
But there are so many ways to spend money, and the ex- 
penditure on any one thing, such as coal, requires ordinarily 
so small a drain on the total power to spend, that the 



Y 


r ^ 


12 ^\^ 




























s 

10^ 


V 
























''\ 












8 \^ 
















< 








^s> 






6'--^. 








6 *». . 
















r 








5^^ 




4^^-., 


3"*—- 


5 




rn- 
















2 


2. 


2- 


2 


2 


o" 






Z 




3 ^ 


)- 5 S. 



Fig. 33. 



294 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

marginal desirability of money is not very different whether 
a man buys no coal at all or all the coal he can afford. 
Consequently in considering the purchase of any particular 
good, the desirabihty of a dollar may be regarded as prac- 
tically a constant quantity, represented, as in Figures 32 
and 33, by the heights of a horizontal row of points. 

In the last chapter we considered the price of coal as the 
effect of supply and demand and expressed by two curves. 
In this chapter we have seen that one of these two curves, the 
demand curve, is in turn the result of innumerable individ- 
ual demand curves; and, finally, that each of these indi- 
vidual demand curves is in turn the result of two desirabihty 
curves — one for coal and another for money — which charac- 
terize the given individual. These desirabihty curves are 
the ultimate curves lying back of demand, and the demand 
curve is, as it were, a desirabihty curve translated into 
terms of money. 

§ 6. Relation of Market Price to Desirability 

We are now ready to see clearly that the market price 
of coal is equal to the ratio between two intensities of 
desire in the mind of each purchaser — the ratio of the 
marginal desirability of coal to that of money. No indi- 
vidual demander of coal can, of course, determine the 
market price of coal. On the contrary, to him the market 
price seems to be fixed, and all that he can do is to adjust 
his purchase to it. But this adjustment, when practiced 
by all the numerous persons who demand coal, constitutes 
the whole demand side of the market, and exerts, therefore, 
a very powerful influence on said existing market price. 
Market price, we have seen, must " clear the market," and, 
appHed to the demand side of the market, this means that 
the market price must be such that when each individual 
on the demand side adjusts his purchase to it in such a 
manner that the ratio of his marginal desirabihty of coal to 



Sec. 6] THE INFLUENCES BEHIND DEMAND 295 

his marginal desirability of money is equal to the price, the 
sum total of all such purchases {i.e., the total demand) shall 
equal the total "supply. 

This principle that the market price of any good is equal to 
the ratio between its marginal desirability and the marginal 
desirability of money for each and every buyer is so important 
that it will be advisable to restate it in as many forms as 
possible. 

Any one of the following statements will show where the 
stopping point of each purchaser is : — 

1. Each purchaser buys until the ratio of the marginal 
desirability of the good to the marginal desirability of 
money is brought into equality with the price. 

2. Each purchaser buys until the desirability of the 
marginal unit becomes equal to the desirability of the 
money spent for this marginal imit. 

3. Each purchaser buys until his marginal gain (of de- 
sirabiUty) is reduced to nothing. 

4. Each purchaser buys until he makes his total gain (or 
surplus desirabihty) a maximum. 

The last two may require further explanation. 

Evidently it is the same thing to say that a purchaser 
stops buying when the desirabihty of the last ton pur- 
chased is equal to the desirabihty of the money paid for 
this last ton, as to say that he stops bujdng when the last 
ton has no excess of desirability over the desirability of the 
money paid for it. 

Let us examine the nature of the gain which the pur- 
chaser makes, and which is thus reduced to zero on the last 
ton. Evidently he gains no money; on the contrary, he 
loses it. What he does gain is desirability. His gain in 
desirability and his " surplus desirability " is the difference 
between the total desirability of the coal he buys and the 
total desirability of the money he has to sacrifice. 

If the price is $5 per ton, in which case Individual No. I, 
as his schedule (or curve) shows, buys 5 tons, the total de- 



296 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

sirability of these 5 tons to him is 41 units of desirability, 
being the sum of the desirabiHties as given in the schedule 
(or curve) for these 5 consecutive tons, viz., 12 + 10 + 8 + 
6 + 5, or 41 ; the sacrificed desirability is the desirability 
of the $25 spent, which, as we assume that each dollar has 

1 unit of desirability, is 25 units; the stir plus desirability is 
the excess of the total over the sacrificed desirability, or 
41 — 25 = 16 units. 

Now this gain of 16 consists of diminishing gains on suc- 
cessive tons. On the first ton the gain is the difference be- 
tween the 12 units which the ton is worth and the 5 units 
he must sacrifice to get it ; tliis is 12 — 5, or 7 units. Likewise 
the gain on the second ton is 10 — 5, or 5 units ; on the third, 
8 — 5, or 3 units ; on the fourth, 6 — 5, or i unit ; and on the 
fifth, 5 — 5, or zero. He stops his purchase at this point, 
for, if he should extend it further, he would lose desirability. 
The sixth ton, for instance, would yield only 4 units and 
cost him 5, and the seventh and later tons would cause 
greater losses. 

Likewise for Individual No. II, who can only afford to buy 

2 tons, the total desirability of these two tons is 12 +10, 
or 22 units; the sacrificed desirability is the desirabiHty of 
the $10 paid, which, as each dollar is supposed to have 2 
units of desirability, is 20 units ; and the surplus desirability 
is 22 — 20, or 2 units. This gain is all on the first ton, as the 
second is worth only its cost. 

Individual No. I thus gains more than Individual No. II, 
though both gain something. 

The last method of stating the principle was that each 
buys so as to m?.ke the greatest possible gain in desirability. 
Evidently, Individual No. I gets his greatest gain by buying 
5 tons. His gains on these 5 tons were, respectively, 7, 5, 3, i, 
and o units, making, as we have seen, an aggregate gain of 
16 units. Had he stopped buying at the third ton, his gain 
would have been one unit less, i.e. , 7-1-5 + 3, or 15 units. 
On the other hand, if he had bought 6 tons, he would have 



Sec. 6] THE INFLUENCES BEHIND DEMAND 297 

lost one unit on the sixth ton, which would have reduced 
his gain from 16 to 15. Thus by stopping at the fifth 
ton he gains the most he can. 

The idea of something, not money, gained in a trade is 
important to grasp. By its aid we have no difficulty in 
understanding that both parties usually gain by a trade. 
Trade does not imply that one of the two parties gains at 
the expense of the other. This is true when one of the two 
parties cheats the other, but ordinary trade is not cheating. 
Nevertheless, the idea that only one party can gain by a 
trade is an old and persistent one. It was largely responsible 
for attempts to regulate prices in the Middle Ages, to make 
the price " just " and prevent one party gaining at the ex- 
pense of the other; it was also largely responsible for the 
sentiment in favor of encouraging the export trade and dis- 
couraging the import trade, — a practice which implied that 
a nation was winning when it sold more than it bought, 
but losing when it bought more than it sold. In fact, the 
phrases " favorable balance of trade " and " unfavorable 
balance of trade," based on this idea, are still in use, al- 
though their original implication of gain or loss is gone. 
We now recognize that the country parting with money by 
buying goods from abroad may gain desirability just as 
the man who parts with money by buying coal gains 
desirability. 

Those who were misled as to a balance of foreign trade 
being " favorable " or " unfavorable " were also misled as 
to the nature of domestic trade. They convinced them- 
selves that trade within a nation was of no consequence to 
that nation. They said it merely changed money and 
goods from one man's hands to another's in the same 
country, and therefore could not increase the wealth of the 
nation as a whole. They failed to see that every exchange 
ajffords " surplus desirability " to both parties engaging in 
it. Each man gets the goods he wants in preference to 
those he already has. The values of the goods exchanged 



298 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

are equal and, as we saw in Chapter V, § 6, these values 
may be canceled against each other when we are making 
up accounts involving values; but, as then stated, this 
does not imply that there is no gain of any kind. We now 
see clearly that there is actual gain and that this gain 
consists in '' surplus desirabiHty." 

§ 7. Importance of the Marginal Desirability of Money 

The student will have noticed that the money element 
was present in all the stages of our study, and is still present 
even when we carry our analysis down to each individual 
mind. A halving of the purchasing power of money halves 
its marginal desirability to each person. But as we have 
seen in the desirability schedules (and curves) of Individuals 
I and II, the marginal desirability of money to the indi- 
vidual is a divisor to be divided into the marginal desira- 
bility of coal to him in order to give the price the individual 
is willing to pay for coal. Therefore, to halve this divisor 
for each individual will result in doubling the quotient — 
the price he is willing to pay. In other words, the prices 
in each individual's demand schedule (or curve) will all be 
doubled by halving the purchasing power of money. Con- 
sequently the same is true of the total demand schedule 
(or curve). This is merely restating what has been said 
before, except that before we considered the demand as a 
whole, whereas now we trace back the effects of a change 
in the purchasing power of money to each individual on 
the demand side of the market. 

We can now see more clearly than in Chapter I how care- 
ful we should be when measuring values in terms of money. 
If our object is to compare desirabilities, we must correct 
our money comparisons for differences in the desirability of 
money. We must make allowance for differences in the 
importance of a dollar (i) among different people according 
to differences in wealth and needs, and (2) between different 



Sec. 7] 



THir, INFLUENCES BEHIND DEMAND 



299 



times or countries according to differences in purchasing 
power of money. 

(i) If a millionaire's wife pays $10,000 for a brooch, while 
her poor neighbor pays $10 for a gown, we should not infer 
that the rich woman prizes her brooch a thousand times as 
much as the poor woman prizes her gown. This would be 
true if the desirability of a dollar were the same in the two 
cases, but as it is likely that the poorer woman prizes a dol- 
lar more than a thousand times as highly as does the richer 
woman, it is altogether probable that the gown is of more im- 
portance to the poor woman than the brooch is to the rich one. 

From the fact that the richer an individual is, the less the 
marginal desirability of money to him or her, it further 
follows that the 
difference in de- 
sirabiHty of two 
fortunes is much 
less than their 
money values 
would suggest. A 
man whose income 
has increased from 
$1000 to $10,000 a 
year is better off 
than when it was 
$1000 a year, but 
he is not ten times 
better off. The 

extra $9000 may Fig. 34. 

not be worth as much as the original $1000, in which case 
he is not even twice as well off. It is still truer that a man 
with a fortune of $500,000,000 is only slightly better off (if 
at all) than one with only $1,000,000. Were these facts 
better appreciated, " great riches," though desirable, would 
be less dazzling to those who have never possessed them. 

In Figure 34, longitude represents the income of a man, 



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V 


















^ 
















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\ 




































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«<l 


































^ 


X 




































■**«. 


•*«. 


"<»• 






































■*- 




^ 





































































X 



300 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

and latitude represents its marginal desirability to him. 
The curve is purely illustrative, as we do not know in 
figures what exact difference in the marginal desirability of 
money is caused by a given increase in a man's income. It 
is intended merely to express the fact that the marginal 
desirability of money (assuming a given purchasing power) 
decreases very rapidly with an increase in income ; that is, 
the richer a person, the less — and very much less — he 
prizes an individual dollar. The curve probably continues 
to the right indefinitely, though approaching closer and 
closer to the base ; no matter how rich a man becomes, an 
additional dollar will still have some desirability in his eyes. 
Man is literally insatiable. 

(2) So much for the allowance to be made between dif- 
ferent individuals. To illustrate the allowance to be made 
for differences in different price levels, we note that money 
wages in the United States are higher, for instance, than 
money wages in England ; but that it is misleading to make 
any comparisons unless we first correct for differences in the 
price levels or purchasing power. In some occupations it 
would seem that the difference in wages only just corresponds 
to the difference in the purchasing power of money, so that 
in those cases the American workman is really no better off 
than the English. In such cases he has more money in 
wages, but its marginal desirability is so much less that he 
has no more desirable food, lodging, or comforts. In most 
cases, however, it is a fact that, after all allowances are made 
for difference in price levels, the lot of the American work- 
man is better than that of the English. 

§ 8. Desires or Wants, the Foundation of Demand 

Evidently desirability is a far more fundamental concept 
than the concept of mere money value. Human desires 
are very real economic influences, and the variations in their 
intensity are definitely registered by variations in the de- 



Sec. 8] THE INFLUENCES BEHIND DEMAND 301 

mand for goods. Although, therefore, "desirabilities" of 
goods and money are somewhat elusive to grasp, they are 
by no means unreal, unimportant, or imaginary. Like the 
heights of the clouds they are difficult to measure, yet 
definite magnitudes. They are, however, magnitudes per- 
taining to separate individuals personally, not to society 
in the mass. It is not surprising, therefore, that as yet we 
have no means of measuring desirabilities by actual statistics 
except in terms of money, and such measurement is mislead- 
ing because it takes no account of differences in the desirabil- 
ity of money to different people or to the same person at 
different times. 

Moreover, to measure desirability in terms of money is 
merely to measure a cause by its effect; for all money 
valuations depend on desirabilities. Although desirability 
is extremely difficult of measurement, even for the individual 
concerned, it is sufficiently measurable to make its study of 
great and fundamental importance in economics. Each in- 
dividual who buys is compelled, in fact, to decide upon the 
relative importance to him of the goods he buys and the 
money he pays for them. It is these decisions, based 
entirely on desirability, which among millions of human 
beings make lip the forces on the demand side of the 
market, on which forces the market prices depend. While 
desirabilities seem fleeting and indefinite as compared with 
the "hard cash" in terms of which we daily express our 
valuations, yet these very cash transactions are simply the 
resultant of innumerable "desirabihties." While the indi- 
vidual desire is fitful, the resultant of the desires of all the 
purchasers is relatively steady, — just as, in physics, the force 
of the individual m^olecules of the atmosphere which bombard 
our bodies are variable and fitful, but the aggregate resultant 
atmospheric pressure is a steady fifteen pounds per square 
inch. 

In this chapter we have endeavored to discover the in- 
fluences at work behind demand. We have found, back of 



302 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVI 

the demand schedule (or curve), the demand schedules (or 
curves) of individuals ; and we have further found, back of 
each individual schedule (or curve), a pair of desirability 
schedules (or curves) , one member of each pair representing 
the desirability of the good, and the other the desirabiHty 
of the dollar. By comparing these two desirabilities, the 
individual finds how many dollars the good is worth to him. 
In other words, he translates the desirability of the good 
into terms of money, which is, as it were, the universal 
language of commerce. 

In some cases the individual is saved the trouble of 
translating into money by the fact that he finds the trans- 
lation has already been made. Thus a commission mer- 
chant, buying on an order from a customer who has already 
told him at what price to buy, has little difficulty in 
making up his mind as to how much money he is willing 
to give. He is willing to give the price at which he is to 
resell to his customer, — less, of course, a slight margin 
for his own commission. So, also, a wholesale dealer, in 
buying of a jobber, is guided largely in his decision as to 
what prices to pay by the prices which he expects to get from 
the retailer, and the retailer is similarly guided by what he 
expects to get from his customer. But even in such cases, 
so far as the dealer finds money valuations ready made for 
him, these must, of course, have been made by some one, 
such as the ultimate customer, through the painful process 
of comparing the marginal desirability of the good with 
the desirability of the dollar. 



CHAPTER XVII 

THE INFLUENCES BEHIND SUPPLY 

§ I. Analogies between Supply and Demand 

In the last chapter we have seen that a total demand 
schedule (or curve) for any particular good is derived from 
innumerable individual demand schedules (or curves), and 
that each individual demand schedule (or curve) is derived 
from a pair of desirability schedules (or curves) , one relating 
to the marginal desirability of the particular good under 
consideration and the other relating to the marginal desir- 
ability of money. 

With certain exceptions to be explained later, precisely 
these same propositions are true of the supply side of the 
market. 

First of all, then, the total supply at any price is merely 
the sum of the individual supplies at that price, as illus- 
trated in the following " supply schedules " for coal for two 
individuals. As before, we distinguish them as Individual 
No. I and Individual No. II (without meaning to imply, of 
course, that they are the same individuals as those called 
No. I and No. II in Chapter XVI). 





SXIPPLY SCHEDTJLES. TONS WHICH 
WOULD BE SUPPLIED BY INDIVIDUALS 




Price 


I 

(a) 


II 

(b) 


Total 
ia + b) 


$4 
S 
6 

7 


ISOO 
i6oo 
i8oo 

2IOO 


2000 
2400 
3000 
3900 


3500 
4000 
4800 
6000 



303 



304 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 



The table tells us that at a price of $4 a ton. Individual 
No. I will supply only 1500 tons and Individual No. II, 
2000 tons ; that at $5 a ton Individual No. I will supply 
1600 tons and Individual No. II, 2400 tons; and so on. 
The last column gives the sum of the figures in the two pre- 
ceding columns. If we should include in our table not 
simply two but all suppliers in the market, we should ob- 
tain in this way the total supply schedule. 

The same relations are indicated graphically in Figure 35, 
where SiSi is the supply curve for coal of Individual No. I, 
i.e., a curve such that if the latitude of any point on it 
represents a given price, the longitude of that point will 
represent the amount of coal the individual is willing to 

supply at that 
price. Similarly, 
S2S2' shows the 
supply curve for 
coal of Individual 
No. II. If, as in 
the case of demand 
curves, we add 
longitudes {e.g., 
Sy = Siy + S2y), we 
obtain SS' as the 
curve representing 
the total supply of 
both individuals. 

If, in like man- 
ner, we add to- 
gether all the 
individual curves of all the individuals in the market, we 
shall obtain the total supply curve of the market. 

Having thus derived the total supply schedule (or curve) 
from its constituent individual supply schedules (or curves) , 
we next seek, as in the case of demand schedules (or curves) , 
to derive each individual supply schedule (or curve) from a 



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7 

e 
5 

A- 
3 
S 
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10 


30 


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mo 


3C 


)00 


<M 


00 


50 


00 


60 


00 






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Fig. 35. 



Sec. i] 



THE INFLUENCES BEHIND SUPPLY 



305 



pair of desirability schedules (or curves). In the case of 
the seller, however, it is not desirability, but wwdesirability 
which needs to be considered, — the undesirability of the 
trouble and expense of supplying coal. Marginal undesir- 
ability is also called marginal cost. 

The following table illustrates the derivation of the seller's 
undesirability curve or marginal cost curve. The figures 
in the last column, found from the second and third by 
simple division, give the prices a coal dealer would be willing 
to take in view of the undesirability of the trouble and ex- 
pense involved in providing coal and the desirability to 
him of the money he seeks to get by selling coal. If the 
1500th ton costs him 8 units of undesirability, and a dollar 
represents to him 2 units of desirability, he will evidently 
be willing to take $4 a ton up to the 1500th ton ; and so on 
for the other figures in the table. 





Undesirability of 


Desirability of 


Price the Dealer 


Tons Sold 


SUPPLYING Last 
Ton 


A Dollar 


WOULD BE willing 

to Take 




(a) 


(b) 


{a-^b) 


1500 


8 


2 


$4 


1600 


10 


2 


5 


1800 


12 


2 


6 


2100 


14 


2 


7 



The same relations may, of course, be represented graph- 
ically. In Figure 36, the latitudes of the points on the 
line rr' represent the undesirability per ton of providing 
the coal, and those of the lower line mm' represent the 
desirability per dollar of obtaining the money. The result 
of dividing the latitudes of the points of r/ by those of 
mm' {i.e., by 2) gives us the supply curve ss', the height 
of which at different points will be proportional to the 
height of corresponding points of the curve r/. The lati- 



3o6 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 



tude of the curve rr' represents the undesirabihty of the 
efforts and sacrifices of furnishing each successive unit, or 

" marginal undesirabihty," 
and the latitude of the 
curve ss' represents, in 
terms of money, this same 
marginal undesirabihty or 
marginal cost of produc- 
tion ; that is, the supply 
curve is the undesirabihty 
curve translated into money. 
This translation of unde- 
sirabihty into money may, 
to a large extent, have 
been already made for the 



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Fig. 36. 



dealer by others. In fact, it will usually happen that the 
larger part of any individual's costs are in the form of 
money expenditures, — expenditures for labor and for ma- 
terials. But these money valuations have themselves 
come about by the process, in the minds of laborers and 
others, of comparing the undesirabihty of efforts with the 
desirabiHty of the dollar. The prices or " latitudes " of 
the supply curve are found, therefore, by translating into 
the universal language of money miscellaneous undesira- 
bihties of all kinds. That is, marginal cost of production 
comprises everything undesirable involved in supplying the 
article under consideration, including all discounted future 
costs, the money equivalent of all labor and trouble, as 
well as all actual money expenses. The seller is more apt 
to think and talk in terms of money than the buyer, since 
the seller has to do with costs, and his costs, as above 
stated, are usually in the form of money costs. Ulti- 
mately, however, as we have seen in previous chapters, 
back of all money costs lie labor costs. Money costs in 
the last analysis are merely the accumulated translations 
into money of labor costs. Labor or human efforts thus 



Sec. 2] THE INFLUENCES BEHIND SUPPLY 307 

stand at the end of our analysis of supply just as satisfac- 
tions stand at the end of our analysis of demand. Supply 
and demand are thus, in a sense, the money equivalents of 
efforts and satisfactions. 

§ 2. Principle of Marginal Cost 

Hitherto we have considered the marginal desirability 
of money as the same whatever the amount of coal bought 
or sold. Expressed in the terms of the diagram we have 
considered the marginal desirability curve for money as a 
horizontal straight line. As explained in the last chapter, 
this was essentially true for the purchaser; but for the 
seller it is often untrue. The purchaser of, let us say, 
sugar will prize a dollar substantially as much whether he 
buys ten or twenty or thirty pounds of sugar a week or 
none at all; the reason is that this one commodity cuts 
little figure in his total budget ; it can make so little inroad 
on his income that it can scarcely affect the desirability of 
money to him. Even in the case of coal, where the ex- 
penditure may perhaps be large enough to pinch the pur- 
chaser appreciably, the desirability of a dollar would prob- 
ably not be noticeably greater if ten tons a year are bought 
rather than five. Each consumer expends his money in so 
many different directions that the part he can, under or- 
dinary circumstances, expend on any one commodity is too 
small to make him feel appreciably poorer as a consequence. 

With the seller of sugar or coal, on the other hand, the 
situation is altogether different. Whereas the consumer 
expends his money in the purchase of a great many differ- 
ent goods, the producer receives his money by the sale of 
a very few. In fact, he may concentrate on one only. 
The coal dealer, for instance, usually makes his living by 
selling coal and nothing else. To him, therefore, changes 
in the amount of coal sold and in the price of coal will 
make a great difference in the total amount of money he 



308 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

gets, and therefore in its marginal desirability. If, for 
instance, the price of coal changes a dollar a ton, though 
to the purchaser this fact will not appreciably affect the 
marginal desirability of money, to the seller it may make 
all the difference between poverty and affluence. 

Therefore, in treating supply, we cannot always assume 
that the marginal desirability of money remains constant 
and may be represented by a horizontal straight line. In- 
stead, the greater the sales, and the more money conse- 
quently obtained, the less will be the. marginal desirability 
of money. Therefore, the line mm', representing the 
marginal desirability of money, should, strictly speaking, 
descend to the right as the sales increase, and the rate of 
descent will depend on the price concerned. This descend- 
ing character of the curve representing the marginal de- 
sirability of money will make the diagram less simple, but 
it will still be possible to derive the supply curve from the 
desirability curves of coal and of money. 

The supply curves thus far considered ascend to the 
right. In such supply curves the price is a minimum rela- 
tively to the supply ; that is, the curve shows the lowest 
prices at which given amounts will be supplied. Express- 
ing this same truth the other way around, we may say that 
the supply is a maximum relatively to the price, i.e., the 
curve shows the greatest amounts which will be supplied 
at given prices. 

We see, then, that the total supply curve, analogously to 
the total demand curve, may be derived from a number of in- 
dividual supply curves (Fig. 3 5) ; that each such individual 
supply curve may be derived from (i) curves of marginal 
undesirability of furnishing the article, and (2) curves of 
marginal desirability of money; and that, therefore, the 
supply curve is, or is equal to, an undesirability curve 
translated into terms of money. 

The important result is that the market price, as finally 
determined by supply and demand, is not only equal to the 



Sec. 2] THE INFLUENCES BEHIND SUPPLY 309 

marginal desirability of getting coal for each buyer, but 
also to the marginal undesirability of furnishing it for each 
seller, both the desirability and the undesirability being 
measured in terms of money. Thus, if the price of coal is 
$5 a ton, the last ton bought by each buyer is worth barely 
$5 to him, while the last ton] sold by each seller costs him 
about $5 worth of expense and trouble. 

These equalities on the margin of all sales and purchases, 
and the fact that the price must be such as will equalize 
supply and demand, i.e., "clear the market," are among 
the fundamental principles which determine the market 
price of any particular good. 

It may be worth while here to emphasize the fact that 
there is a separate market at each stage in the operations 
by which coal passes from producer to consumer. At 
each stage supply and demand fix a price for the market at 
that stage. The first market for coal is at the mine, the 
sellers being the producers and the buyers, middlemen, who 
later wUl resell. The market price at the mine is, of 
course, quite different from the market price later in the 
wholesale market, and the latter market price is different 
in turn from that in the retail market. But the same 
principles apply to aU these market prices. 

We may summarize these principles as follows : — 

(i) The equalization of all marginal desirabihties and 
undesirabilities (both being measured in money). 

(2) The equalization of supply and demand. 

We cannot neglect either of these two principles. Nor 
can we omit either half of the first principle ; it is a mistake 
to think that price can be determined by marginal desira- 
bility alone or by marginal undesirability alone. It takes 
two sides to make a bargain and a market price. 

The present chapter, however, is especially devoted to 
the supply side. On the supply side of the market, there- 
fore, the great determinant of market price (in terms of 
money) is marginal cost (in terms of money) . 



3IO ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

These two determinants of price — marginal desirability 
and marginal cost — are, as has been explained, human 
desires translated into money. Marginal desirability rep- 
resents the desire to secure something agreeable, while 
marginal cost represents the desire to avoid something 
disagreeable. 

In this connection it is important to remember that both 
the " something agreeable " which we desire to secure, and 
the " something disagreeable " which we desire to avoid, lie 
in the future. When an intending purchaser of an orchard 
speaks of it as a desirable object, he means that he has a 
desire in the present for certain expected satisfactions in the 
future, — satisfactions from eating the apples or other future 
benefits which the ownership of the orchard is expected to 
bring. Likewise when the owner of a coal mine decides 
which leads or galleries he shall exploit, he bases his decision 
on what he expects the extraction of coal to cost. The 
marginal desirability to the purchaser of the orchard repre- 
sents future satisfactions translated into present cash by 
the usual process of discount, and the marginal cost of coal 
extraction represents future expected costs translated into 
cash by the same process. Later, when the expected satisfac- 
tions or the expected costs have become past history, they 
no longer control marginal desirability or marginal cost. It 
is the costs of the future, and not of the past, which always 
control. After the coal miner has exploited the lead or 
gallery, and it turns out to have cost more than he ex- 
pected, he will not on that account obtain a higher price 
for the coal than he originally calculated. Again, if a rail- 
way has been built and located unwisely, its value may fall 
far short of its original cost. It is important that the 
student should carefully avoid the error of believing that 
the prices and values are controlled by what things have 
cost to produce in the past. In the case of staple articles, 
however, which are constantly being reproduced, and of 
which the cost does not greatly vary from time to time, the 



Sec. 2] THE INFLUENCES BEHIND SUPPLY 311 

price will come to be approximately equal to this cost ; for 
the cost of reproducing in the future will be practically the 
same as the cost which has been experienced in the past. 
Even in these cases, however, it is the cost which is ex- 
pected to continue in the future rather than the cost which 
has been experienced in the past, that furnishes the con- 
trolling motive to the producer in determining at what 
price he will supply his product. 

We may here call attention to the fact that the principle 
of marginal cost applies to the particular case of gold as a 
commodity, priced in terms of wheat, or priced in terms 
of all other commodities in general — which is the same 
thing as saying, priced in terms of its general " purchasing 
power." During part of our discussion of money, we did 
thus treat gold as a commodity. If the student will turn 
to Figures 13-16, he will see that the distance below the 
line 00 of the highest outlet in operation from any 
bullion reservoir is simply what we would now call the mar- 
ginal desirability of gold for use in the arts (measured in 
terms of general purchasing power over goods), and that 
the distance from 00 to the lowest inlet in operation is the 
marginal cost of production or undesirability of gold (meas- 
ured likewise in terms of general purchasing power over 
goods). That is, the mechanical representation there em- 
ployed is merely another way of representing what we 
would now express in terms of supply and demand of gold. 

We may now add that the differences in costs of producing 
gold, represented by the differences in heights of the inlets, 
are not altogether due to differences between mines, but 
also to differences in working the same mine. There is a 
marginal cost of production for each mine. The higher the 
speed of extracting, the higher the cost per ounce. This is 
called the law of increasing cost.^ It applies, of course, 

^ It is also called the " law of diminishing returns." The two expres- 
sions are evidently equivalent. Each statement expresses the effect of 
increasing production on the relation between product and cost. If with 



312 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XVII 

more generally than to gold and silver alone. In this 
chapter we have taken coal as our typical example. We 
might have taken numerous other examples. If the price 
of wheat rises, its marginal cost will rise. Such a rise in 
price acts as an encouragement to the production of wheat. 
Just as we have seen that an encouragement in the produc- 
tion of gold leads to an opening of the poorer mines, so an 
encouragement to the production of wheat will lead to the 
cultivation of the poorer wheat lands. At a given price, 
there are always some lands on which it will not pay to 
produce wheat because of the prohibitive cost of production 
upon these lands. In gold mines, as in wheat fields, there 
is a marginal point of production beyond which production 
will not pay. 

§ 3. Upward Supply Curves which Turn Back 

In spite of the analogies we have noted between the supply 
and the demand side of the market, the differences between 
them are so great and important that the rest of this chapter 
will be devoted to them. 

Practically all demand curves descend to the right, and 
we have hitherto assumed that all supply curves ascend to 
the right. But not all supply curves do ascend to the right. 
One pecuHar t3q3e of supply curve grows out of the fact re- 
cently noted, that there is a descending curve of marginal 
desirability of money dependent on the price assumed. 
This fact, when combined with the ascending curve of un- 
desirability of efforts and sacrifices (as in Fig. 36), tends to 
bend the supply curve upward — sometimes so much as to 
cause it to curl back to the left, as in Figure 37. Such a 
curve, although it ascends, does not, throughout all its 

increasing production the ratio of cost to product increases it is the same thing 
to say that the ratio of product to cost decreases. The one form of statement 
is that there is greater and greater cost per unit of product returned; the 
other, that there is less and less product per unit of cost incurred. 



Sec. 3] 



THE INFLUENCES BEHIND SUPPLY 



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course, ascend to the right. It applies especially to the sup- 
ply of labor. The meaning of such a supply curve is that a 
rise of price does 
not always cause 
an increase of 
supply. At first 
it does, but be- 
yond the point 
where the curve 
begins to curl 
back, a rise of 
price evidently 
results in reduc- 
ing the supply. 

If wages are 
low, a rise in 
wages will at first 
stimulate him to 
work longer 
hours, but after a certain point, he will prefer to rest on his 
oars. He earns so much in a few hours that he feels it is 
no longer necessary to work so hard. In South America, 
for instance, traders from Europe were once buying native- 
made baskets of a peculiar kind. In order to increase the 
supply of baskets, which was far less than they could mar- 
ket in Europe, the traders decided to raise the price that 
they would offer to the makers, thinking to stimulate the 
production of baskets by inducing the men to work more 
hours. Exactly the opposite result followed. As soon as 
these workmen were offered high prices for the baskets, 
they worked fewer hours and made fewer baskets than 
before ; they could now get more money even for doing less 
work, and they did not need or want more money. Their 
wants were so few and simple that the marginal desirability 
of money to them decreased very rapidly with an increased 
amount of it; and their disinclination to work was so 



Fig. 37. 



314 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XVII 

great that, combined with the feeble desirability of its 
rewards to them, they would supply less of it when 
the rewards w^ere great than when they were small. Similar 
instances have been cited among the Filipinos and among 
the negroes in the South. Recent experiments in coal 
mines show that a slight increase in wages stimulates the 
men to work longer, but that a large increase (sixty per 
cent beyond the ordinary wage) results in irregularity of 
work and the desire to reduce the number of hours. That 
is (as shown in Fig. 37), as the price rose from the 
height of 5' to that of s", the supply of labor or number 
of hours spent in making baskets decreased from the longi- 
tude of s' to the longitude of s". 

Now this same principle applies to all labor. Experience 
indicates that as wages go up workmen demand shorter 
hours. The eight-hour movement of to-day is at bottom 
due to the fact that wages are high. When wages were low, 
men worked twelve hours a day ; now that they are 
high, they work only ten, nine, or even eight hours a day. 
The same principle explains why men with the highest 
salaries, instead of working longer hours than others, usually 
work shorter hours. The most highly paid grades of work- 
men work the fewest hours and take the longest vacations. 

The exact point in wages at which the curve begins to 
bend back, so that if wages are raised any higher the supply 
of work will diminish, depends on the particular conditions 
in each case, the size of the workman's family, the range 
and character of their wants or their " standard of living," 
and other similar conditions. The more wants a man has, 
the .higher the point at which the curve begins to bend back, 
i.e., the less easily is he satisfied with more money. 

§ 4. Downward Supply Curves 

The tj^ical supply curve, with which we began, ascends 
continually to the right. A different type was just consid- 



Sec. 4] THE INFLUENCES BEHIND SUPPLY 315 

ered, one in which the rightward movement was arrested 
and turned into a leftward movement. A still different 
type is that in which the curve does not even ascend, but 
descends. Such descending supply curves are common 
under modern conditions of factory production. It is often 
found that a large product costs less trouble, per unit, than 
a small product. In such cases, the marginal undesira- 
bihty of furnishing the good decreases with an increase of 
supply, and not only decreases, but decreases in a faster 
ratio than does the marginal desirability of money ; so that 
the ratio of the one to the other, i.e., the marginal cost 
expressed in money, decreases with an increase of supply. 

When the marginal cost decreases with an increase of 
supply, the supply curve also descends, but its relation to 
the curve of marginal cost is now quite different from what 
it was in the case previously considered in which the curves 
ascend. The supply curve is no longer the curve of margi- 
nal costs, but must be constructed on an entirely new 
principle. The principle that market price is equal to 
marginal cost will no longer hold true. Only when the 
supply curve ascends is it true that the price at which the 
seller is willing to supply a given amount is equal to its 
marginal cost, and is therefore derived from the curves of 
undesirability. Descending supply curves, which we are 
about to consider, depend not on margi?tal cost at all, but 
on average cost. The reason is that no seller is willing regu- 
larly to sell at a loss, and this is what he would be doing 
if he should offer to sell at prices corresponding to marginal 
cost when the marginal cost decreases with the amount sold. 
It is clear that, if the cost of supplying the 3000th ton of 
coal is $5, and the cost of all preceding tons is greater than 
$5, not even one ton of coal could be sold at $5 a ton with- 
out a loss, and if 3000 tons were sold at that price, there 
would be a loss on every ton except the last. Rather than 
sell 3000 tons or any less number at $5 a ton, the dealer 
would choose to sell none at all. Contrast this result with 



3l6 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

that which obtains in the case of an ascending curve. In 
this case, if the cost of supplying the 3000th ton were $5, 
the cost of all preceding tons would be less than $5, so that 
instead of a loss there would be a gain on each of these pre- 
ceding tons. Not only could he afford at $5 to sell 3000, 
but this amount gives him the maximum profit — more, for 
instance, than if he should sell 2000 or 4000 tons. 

Now whether the cost curve ascends or descends, it is 
clear that any dealer to sell at all, must expect to get back 
at least the total cost. This means that he must, therefore, 
charge a price at least as high as the average cost per ton. 
When the cost of each successive ton is greater than that of 
the preceding ton, the cost of the last, or marginal cost, is the 
greatest cost of all, and therefore exceeds the average cost. 
Consequently, the dealer is assured a profit when selling at a 
price equal to the marginal cost. But when the cost of each 
successive ton is less than that of the preceding ton, the 
cost of the last ton (marginal cost) is the least of all, and 
therefore is less than the average cost. To sell at a 
price equal to marginal cost would, in this case, mean to 
sell at a loss. 

In either case, whether the curve ascends or descends, 
the seller will seek to determine his price on the basis of 
the higher of the two costs (marginal and average) . Which- 
ever of the two is the higher will show itself in the supply 
curve. When the marginal cost increases with supply, 
marginal cost is the higher, and will rule supply. When 
the opposite is true, average cost is the higher, and will 
rule supply. 

In the latter case the supply schedule (or curve) is a 
schedule (or curve) of average costs. We need not describe 
in detail how to construct such a schedule (or curve) . This 
presents no difficulty, since we already know how to con- 
struct a schedule (or curve) of marginal costs which gives 
the cost individually of each separate ton. The simple 
average of any specified number of these is the average 



Sec. s] THE INFLUENCES BEHIND SUPPLY 317 

cost of that number. This average-cost-curve will descend, 
though it will be higher than the marginal-cost-curve from 
which it is calculated.-^ 



§ 5. Resulting Cutthroat Competition 

But, besides the fact that ascending supply curves are 
based on marginal costs, and descending supply curves are 
based on average costs, the two types of supply curves offer 
another and even more important point of contrast. The 
supply at a price is in the first case the maximum which 
the seller is willing to offer at that price, whereas in 
the second case it is the minimum. In the first case, 
the more the seller can sell, the more he charges. In the 
second, the more he can sell, the less he charges. When 
we consider simply ascending types of supply, we may ex- 
press the relation between the price and supply in two 
ways, either — 

(i) Given the quantity, the price is the minimum price 
at which that quantity will be supplied ; or 

(2) Given the price, the quantity is the maximum which 
will be supplied at that price. 

The first of these two propositions still holds true when 
the supply curve is descending instead of ascending; but 
the second will not hold true until we have changed the 
word " maximum " to " minimum." In other words, when, 
as originally supposed, the supply curve ascends, the seller 

^The relation between cost and product represented by a descending 
supply curve is sometimes called the "law of decreasing cost" and some- 
times the law of " increasing returns " ; for, it is evidently the same thing 
to say that the ratio of cost to product decreases as to say that the ratio of 
product to cost increases. The one form of statement is that there is less 
and less cost per unit of product returned ; the other that there is greater 
and greater product per unit of cost incurred. These expressions are in 
antithesis to the "law of increasing cost" (or, the "law of diminishing 
returns ") of § 2. There is, theoretically, an intermediate condition 
called the " law of constant cost " (or "law of constant returns"). 



3l8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

is willing at any given price to supply a certain amount 
or less; but, when the supply curve descends, he is willing 
at any given price to supply a certain arnount or more. 

In the case of demand we found no such two classes as 
ascending and descending curves. In all cases demand de- 
creases as price increases. Consequently we found only 
one sort of relation between price and demand. The 
amount demanded at a price is always the maximum 
amount which will be taken at that price; and the price 
is always the maximum price which will be given for that 
amount. 

Let us then summarize our results, expressing each on 
the basis of a given price : — 

I. At a given price, each buyer is willing to take a certain 

maximum amount or less at that price. 
II. At a given price, each seller is willing 

(i) (in case marginal cost increases with an increase 

of supply) to offer a certain amount or less at 

that price. 

(2) (in case marginal — and therefore also average — 

cost decreases with an increase of supply) to 

ofTer a certain amount or more at that price. 

The contrast between the two types of supply, II (i) and 

II (2), is illustrated graphically in Figures 38 and 39. Figure 

38 illustrates case i and Figure 39, case 2. The curve in the 

first case is seen to be the maximum limit of longitude, and 

in the second case the minimum limit. The longitude of 

any point in the shaded area represents an amount which 

the seller is willing to supply at the price corresponding to 

the latitude of that point. Thus, if we take any given 

horizontal line, such as ab, in the shaded area of Figure 38, 

its latitude represents an assumed price at which the seller 

is willing to supply any amount, from nothing at the left 

end, a, of the horizontal line, to the maximum amount at 

the right end, b, where the line is limited by the curve. 

Taking any given horizontal line, such as ab, in the shaded 



Sec. s] 



THE INFLUENCES BEHIND SUPPLY 



319 



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Fig. 38 (Supply). 



area of Figure 39, the seller is willing to supply any amount 

from the minimum longitude (that of the point a at the left) 

up to an indefi- 
nite amount at 

the right; or, 

dropping the 

symboKsm of the 

curve, the seller is 

willing at a given 

price to sell any 

amount from a 

certain minimum 

upward. 

In tJie latter 

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the cost of each 

additional unit of 

product is less 

than that of the preceding unit, the more the seller can sell 

at a given price, the better he likes it. If he sells only the 

minimum which he 
is willing to sell at 
that price, he gets 
back only his 
average cost of 
production, and 
makes no profit. 
Any sales beyond 
this bring him a 
profit, and the 
larger the sales, the 
larger the profit. 
He stands ready to 
seU an indefinitely 
great amount at 
Fig. 39 (Supply). the given price. 



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320 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

This fact introduces us to an unexpected conclusion, viz., 
that if the total supply curve descends, the price repre- 
sented at the intersection of the supply and demand curves, 
although it clears the market, is not a stable price, but 
tends always to fall. Whether the price is above, at, or 

below, the latitude of the 
intersection, it will tend to 
fall so long as the supply 
curve descends. Let us 
consider each of these 
three cases separately, i.e., 
the price above, at, or be- 
low the intersection, allow- 
ing the demand curve to 
descend faster than the 
supply curve. If the price 
(Fig. 40) is OP, higher 
than the intersection, the 
demand exceeds the mini- 
mum supply and stimulates each supplier to furnish more 
than his minimum, which, of course, he is only too glad 
to do. Consequently, supply will soon overtake demand. 
Those competing to supply will strive to underbid each 
other, and the price will fall. 

But it will not stop falling at the intersection. For, sup- 
pose it is below, as at OP' . It is evident that it will con- 
tinue to fall ; because then even the minimum supply exceeds 
the demand, and all who compete to supply will be very eager 
not to be left with unsold goods or unused productive capac- 
ity. A rise of price would, it is true, remedy the difficulty. 
But no individual can apply this remedy. The individual 
competitor cannot raise prices without securing the agree- 
ment of others ; but to do this would be to create a combina- 
tion which is contrary to our present hypothesis of independ- 
ent action. If he should individually raise his price, he would 
be committing commercial suicide, for people would not buy 




Sec. 6] THE INFLUENCES BEHIND SUPPLY *32I 

of him when they could buy more cheaply of his competitors. 
His only hope of achieving his purpose of increased sales 
lies in adopting the opposite course, and underselling his 
competitors, regardless of the consequences to them and to 
the market price. His hope is that before they can meet his 
cut in price, he may win the patronage he needs to make it 
worth his while to stay in the market, and that he may thus 
drive some of his competitors out of business. If he fails 
to get the needed patronage, he must go out of business him- 
self. He therefore offers his wares at a price below OP' . 
If at this point many of his competitors should go out of 
business, he could succeed ; for though the total demand 
does not quite reach the supply curve, it will reach and pass 
his supply curve, which lies much to the left of the total 
supply curve shown in the figure. But his competitors 
remain, and under these conditions, as we have seen, there 
cannot be two prices in the same market at the same time. 
Hence all his competitors must reduce their prices to his. 

Whatever the effect of this action may be on the indi- 
vidual who first cuts the price, the result on the whole is 
evidently to make matters worse; for, according to con- 
ditions shown in the diagram, the lower the price, the more 
will the supply exceed the demand. 

We have here what is known as " cutthroat competition " 
or a " rate war," i.e., competition the effect of which is not 
simply to reduce profits, hut to create losses. 

§ 6. Resulting Tendency toward Monopoly 

But we have not yet reached the ultimate result of such 
competition. Some competitors must sooner or later see 
that there is no hope to secure the large sales necessary 
to make business worth while. They withdraw. This re- 
duces the losses for the rest ; for, by removing their supply 
curves, the total supply curve is reduced in longitude, i.e., 
is shifted leftward, and the discrepancy between supply and 



322 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

demand is lessened, if not done away with entirely. But 
even so, the tendency of the price to fall is not hindered ; for 
we have seen that, as long as the supply curve decreases, 
competition forces the prices down on whichever side of 
the intersection the price may be. In the case of a descend- 
ing supply curve, the intersection has nothing to do with 
the case. Competition with descending supply curves will 
always lower the price so long as there are any competitors 
with descending supply curves. No check to this fall is 
possible until either competition ceases or the supply curve 
ceases to descend. If the supply curve at some point at 
the right reaches a minimum point, this marks the lowest 
point to which the price can fall; or if the crowding out 
of competitors finally leaves only one supplier in the iield, 
he at that moment becomes a monopolist, and the prices will 
cease falling on that account. 

Not only may monopoly come about by this process of 
" the survival of the fittest," but it may also come about 
in another way, as already suggested, i.e., by combination. 
When there is cutthroat competition, the motive to combine 
is strong. No one of the competitors relishes the prospect 
of being crowded out any more than he relishes the prospect 
of continued cutthroat competition. Whether combination 
will actually result or not depends on a variety of circum- 
stances. One or more of the competitors may flatter himself 
that the rate war will end in crowding out all suppliers except 
himself, and prefer to keep up the fight to the bitter end. 
Others may keep on from other motives, being prevented by 
pride or resentment either from withdrawing from the contest 
or from begging their rivals to form a combination. But for 
our present purpose it does not matter much whether the 
monopoly which finally results comes from the final survival 
of one supplier or from deliberate combination of many sup- 
pliers. In either case the result is monopoly. 

We find, then, from our study of the supply side of the 
market that supply curves sometimes descend, and that in 



Sec. 7] THE INFLUENCES BEHIND SUPPLY 323 

such cases competition is " cutthroat " competition, and re- 
sults in losses and tends toward monopoly. 

In all our reasoning we have assumed perfect competition 
to start with. It should be noted that in actual fact com- 
petition is always somewhat imperfect. The slight under- 
cutting of prices by one grocer will not ruin the trade of 
another in another part of the same town for the reason 
that the two are not absolutely in the same market. Each 
has a sphere which the other can only partially reach, not 
only because of distance, but also because each has his own 
" custom," i.e., the patronage of people who, from habit 
or from other reasons, would not change grocers merely 
because of a slight difference in price. Thus each is pro- 
tected by his partial isolation. We see, then, that even when 
supply curves descend, competition may be so limited as to 
prevent any very fierce rate war, the rate war being pre- 
vented by partial or local monopolies among the suppliers 
in the first place, A rate war, therefore, is never a perma- 
nent or normal condition. If not avoided at first by imper- 
fect competition or by partial monopoly, it is brought to an 
end eventually by the monopoly to which it leads. 

§ 7. Fixed and Running Costs 

We have now to notice another peculiarity on the supply 
side of the market. The peculiarity referred to is the fact 
that there are often costs which do not vary with supply, but 
remain unchanged whether the supply is large or small or 
nothing. These are called the fixed costs as contrasted 
with the costs which vary with supply, which are called the 
running costs. If all costs are in the form of actual money 
expenses, the two classes are also called respectively fixed 
expenses and running expenses. The fixed expenses of a 
railway company, for instance, consist of the interest on 
its bonds. The running expenses consist of the salaries, 
wages, and payments for fuel, materials, etc. The only 



324 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

costs hitherto included in our discussions were running costs. 
The fixed costs were not included, because they have no 
effect on variations in supply curves. We shall now study 
fijced costs merely to show that they do not have any effect 
on supply after once they have been incurred, a fact at first 
surprising. 

In general, fixed costs of production of any given goods 
consist simply of interest on past costs which have been 
" sunk " in the business, i.e., which cannot now be reim- 
bursed to the owner except as the sale of his goods may re- 
imburse him in part or in whole. As we have seen in a 
previous chapter, interest is not a cost to society, for it is 
merely a payment from one person to another, an interac- 
tion. (See p. 76.) To society as a whole the only cost is 
the " sunk " cost, which, in the last analysis, consists, as 
has been explained, of the labor expended at various times 
in the past. But to the individual suppHer — and his is 
the only cost in which we are at present interested — in- 
terest is a cost. If he pays no interest, he must have in- 
curred the " sunk " cost himself, in which case this past 
sunk cost constitutes his only fixed cost ; there is then no 
fixed annual cost. In one of the two ways he must bear 
the burden of sunk cost. That is, either he must have 
borne it in the past directly, or he must now be paying 
interest to some one else who so bore it. The two ways are 
equivalent in the same sense that two goods are equivalent 
which exchange for one another. That is, a sunk cost of 
$100,000 is equivalent, if interest is five per cent, to a 
fixed cost of $5000 a year. Whether the individual person 
or company has sunk the $100,000 in the past or is paying 
$5000 a year to some one else who did — in neither case 
does this cost enter into the cost (or undesirability) curve, 
or the resultant supply curve, or the resultant price. 

We shall cite some examples which have been almost 
literally reahzed in actual life. A man once sunk about 
$100,000 in a hotel on the top of a mountain. He found 



Sec. 7] THE INFLUENCES BEHIND SUPPLY 325 

that SO few guests wanted to go there that the most he 
could earn was $2000 beyond his running expenses. He 
never succeeded in recovering the sunk cost, and the fact 
that he had sunk $100,000 gave him no power to com- 
mand prices high enough to enable him to succeed. Nor 
could he withdraw from the business and recover his 
$100,000. His building was worth nothing except for 
hotel purposes. He could only make the best of his mis- 
investment and run his hotel for $2000 a year. This 
was better than nothing at all, which would have been 
the result of going out of business. The $100,000 sunk 
in the past was sunk just the same, whether the hotel 
was run or not. 

Another hotel keeper borrowed $100,000 on bonds and 
paid interest at five per cent, i.e., $5000 a year, to 
the bondholders. His business paid running costs, but 
only $2000 beyond those costs, so that he failed by $3000 
to earn enough to pay his interest to the bondholders. 
The hotel was losing, in actual money expended, $3000 a 
year. But even in this case the hotel could not be aban- 
doned. The only result was to change owners. The bond- 
holders foreclosed their mortgage and ran the hotel them- 
selves. As it still earned $2000 beyond running expenses, 
they found it more profitable to continue the business and 
get two fifths of their interest than to close and get nothing. 

In either of these two cases, whether the hotel was built 
by the owner out of his own purse or whether it was built 
out of borrowed money, there was a loss equivalent to three 
fifths of the original cost, or, what amounts to the same 
thing, three fifths of the interest thereon. Yet this cost 
could not be avoided, whether the hotel business were large 
or small or abandoned altogether, and it " paid " to run at 
a loss rather than to close down at a greater loss. This 
paradox, that " it sometimes pays to run at a loss," is im- 
portant to analyze and to understand. 

A third hotel keeper made a lucky hit with his $100,000. 



326 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

He got not only his running expenses and interest on the 
$100,000, but a handsome profit besides. But this fact did 
not affect the prices at which he was wilHng to supply ac- 
commodations. He still charged as much as he could. 

The point to be emphasized is that in all three cases the 
past fixed costs had no influence on prices. Whether these 
costs are easy to carry, as in the last case, or burdensome, 
as in the other two, they have no influence on prices. In 
each case the owner tries to make the most he can. The 
fijfed costs take out the same amount, whatever he does, and 
may therefore be disregarded in deciding what is best to do. t)L 

It follows that fixed costs will not even prevent prices, 
under the stress of competition, from going below what will 
pay those costs. A railway may be making money enough 
to pay both its running and fixed expenses and a handsome 
surplus besides, until a parallel road is built. Then each 
tries to take business away from the other ; a rate war en- 
sues, and prices of freight and passenger services are driven 
down. Each road is now running behind on its interest 
payments, yet neither can afford to stop running, for then 
it would run behind still further. We have here the same 
cutthroat competition as when the supply curve descends, 
except that in this case it is " cutthroat " because of the 
fixed costs. If also the supply curve descends, then there 
are two conditions tending toward cutthroat competition ; 
namely, the existence of the descending supply curve and 
the existence of fixed costs. As a matter of fact, these two 
conditions are often united. 

§ 8. General and Particular Running Costs 

The two costs — fixed costs and running costs — are not 
only often associated, but are at bottom very similar to 
each other. This may best be seen if we divide one of 
the two classes of costs, running costs, into two subclasses, 
" general " costs and " particular " costs. By general 



Sec. 8] THE INPLUENCES BEHIND SUPPLY 327 

costs, also called " overhead costs," are meant costs which, 
though they could be got rid of if the business ceased, will 
not greatly vary whether the business is large or small. 
They include the labor of superintendence, salaries of the 
chief officers, rent of rented quarters, interest on short- 
time loans for stock carried, etc., power, lighting and heat- 
ing, insurance and repairs. By particular costs are meant 
those which apply to each particular unit so that their total 
amount will vary almost or quite in proportion to the 
amount of product sold. They include cost of raw mate- 
rials and ordinary wages. 

Now when the supply curve descends, i.e., when running 
costs decrease with increase of supply, the reason is usually 
found in the " general costs." As the total " general costs " 
remain little changed by an extension of the supply, the 
general costs per unit suppHed grow smaller, the larger the 
supply. These costs, added to the particular costs, which re- 
main practically the same, evidently cause the total running 
cost per unit to decHne with an increase in production. For 
instance, let us suppose a shoe factory in which the general 
costs (for office salaries, heating, lighting, rent, insurance, 
etc.) amount to $100,000 a year, while the particular costs 
for materials (leather, etc.) and labor applied to the mate- 
rials (cutting, sewing, etc.) amount to $1 per pair of shoes. 
It is evident that the greater the product, the less the cost 
of shoes per pair. If 10,000 pairs are produced per an- 
num, the share of the general costs ($100,000) which each 
pair must bear will be $10. This, added to the particular 
cost for each pair ($1), will make a total cost per pair of 
$11 ; but if the output of the factory is 100,000 pairs, the 
share of the general cost ($100,000) which each pair must 
bear will be only $1, which, added to the particular cost ($1 
per pair), will make a total cost per pair of $2. Thus we 
see that the total cost per pair will in each case be the 
particular cost, $1, plus the share in the general cost, which 
will be large for a small output and small for a large output. 



328 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

Now the reason that fixed costs were not treated like 
general costs and included in the computation of the 
average cost per unit, was that, as we have seen, fixed 
costs could make no difference in the price at which the 
suppHer is wilKng to supply a given amount. The supplier 
is not willing to sell at prices below what is necessary to 
cover general costs, for he has the option to escape these 
general expenses by going out of business entirely. But 
he is willing, if need be, to sell at prices below what is nec- 
essary to cover fixed costs in addition to general costs ; for 
from these there is no way of escape, not, at any rate, as 
long as the capital representing fixed costs lasts. He 
might have escaped them once had he not made the 
original' investment, but now it is too late. The differ- 
ence between fixed and general expenses, then, is chiefly 
one of dates. When a man is contemplating building a 
hotel, and forecasting his possible profits or losses, he will 
try to make his prospective prices cover fixed costs, for they 
are then in the future ; but after the hotel is built, he will 
no longer do this. The fixed costs are then past and beyond 
recall, and he must let bygones be bygones. 

Since, then, his running cost and supply curves are inde- 
pendent of fixed costs, the price which results from this 
supply curve and the demand curve will also be independent 
of the fixed costs. This conclusion is consistent with what 
has been said in previous chapters as to price and value being 
dependent on the future and not on the past. We have 
seen that, on the demand side, people who buy any good 
buy it on the basis of what benefit it will do them in the 
future; now we see that, on the supply side, those who 
sell it, sell it on the basis of what it will cost them in the 
future to continue in the business, and not on the basis of 
costs which were sunk in the past. The principle has been 
stated (somewhat imperfectly) as follows : — 

" The price of any article (when once it has been produced) 
is not determined by its cost of production, but only by its 



Sac. 9] THE INFLUENCES BEHIND SUPPLY 329 

benefits." The imperfection in this statement is its failure 
to discriminate past from future. The costs of production, 
if they be future, do enter into value, precisely as future 
benefits enter. Future costs are estimated in advance 
just as future benefits are. For instance, the value of the 
great irrigation plants in the West now in process of con- 
struction is dependent upon their future expected bene- 
fits, taken in connection with the future expected cost of 
completion. Past elements are without significance. The 
future elements being given, the value of the irrigation will 
be the same whether the past cost was large or small, or noth- 
ing whatever. Of course it is true that the future expected 
cost of completing the plants is less than if some of the work 
had not been already accomplished, so that the greater the 
past cost has been, the less the future cost ought to be, and 
hence the greater the present value of the plants. But what- 
ever causes may increase or decrease future benefits and costs, 
it remains true that the present value of anything depends 
exclusively on the future benefits and costs which it yields. 

§ 9. Monopoly Price 

The supreme principle which guides economic action is 
the principle of maximum gain. This principle applies 
both to competition and monopoly, but its application is 
different in the two cases. In the case of competition the 
price set by a man's competitors is an important element 
which must be reckoned with by that man, while in the case 
of monopoly he has no such element to reckon with. In 
fact, monopoly is best defined as absence of competition. 

In explaining the principle on which monopoly price is 
fixed, we shall first assume that competition is entirely 
absent, there being no fear even that high prices will lead 
to competition in the future. 

Under these circumstances the monopolist will fix his 
price with an eye to the expected effect on demand. He 



330 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

will charge " what the traffic will bear," i.e., will put up 
his price to the point which will give him a maximum profit. 
The higher the price, the larger the profit per unit sold. 
But, if he makes his price too high, he kills the sales. If, 
on the other hand, he makes it too low, he kills his profit 
per unit. By trial and error or by exercise of his best judg- 
ment, he steers a middle course, and selects that price 
which he thinks will render his profit a maximum. 

In general, the price under monopoly will be higher than 
under competition, but this will not always be the case if, 
as may happen, the costs under monopoly are less than the 
costs under competition. In some cases monopoly may result 
in lowering costs so much that the greatest profit is secured 
by setting the price lower than under competition. Such 
economies in cost come from getting rid of dupHcations in 
plant, management, and advertising, and by having the 
advantages in general of large-scale production. 

When monopoly price exceeds price under competition, 
there is usually danger that competition will thereby be 
invited. Practically such danger is seldom absent. Com- 
petition which is feared, but not in actual existence, is called 
potential competition. This potential competition has an 
eflect similar to real competition, so that under monopoly 
the price is usually not quite " all the traffic will bear," but 
something between that and the price that would result from 
actual competition. In general, prices are seldom deter- 
mined under conditions either of perfect monopoly or of 
perfect competition. There is usually a partial monopoly, 
or, what is the same thing, imperfect competition. 

There are many and obvious evils in monopoly. Some 
' monopolies originate in a deliberate plan to do evil, in a 
"conspiracy" to raise prices and without any excuse from 
cutthroat competition. But the evils of high prices are 
among the least of the evils of monopoly. There are also the 
evils involved in the ruthless process of crushing competitors 
( by first lowering prices and then raising them ; there are 



Sec. 9] THE INFLUENCES BEHIND SUPPLY 33 1 

the evils of discrimination, or charging different prices to 
different persons or localities. There are also the dangers 
of political corruption and control. The reader will have 
an opportunity in other books to study these evils and the 
proposed remedies ; we cannot properly discuss them here. 
We may, however, take space to warn him to avoid the 
common but false conclusion that all monopoHes are evil. 
In fact, a chief lesson from this chapter is that, on the 
contrary, competition itself is sometimes an evil, i.e., when 
it is of the cutthroat kind, for which some form of mo- 
nopoly is the only remedy. When any business involves a 
large sunk cost or has a descending cost curve, and there- 
fore a descending supply curve, competition becomes of the 
cutthroat kind. Even if we deny our sympathy to those 
producers who lose by such competition, we must not fail 
to note that in the end consumers will lose also. The 
reason is that when cutthroat competition is feared, pro- 
ducers will avoid sinking capital in the enterprise. It 
is largely in recognition of this fact and in order to en- 
courage such investment that patents and copyrights are 
given. These are monopolies expressly fostered by the 
government. Herbert Spencer once invented an excellent 
invalid chair, and, thinking to give it to the world without 
recompense to himself, did not patent it. The result was 
that no manufacturer dared risk undertaking its manu- 
facture. Each knew that, if it succeeded, competitors would 
spring up and rob him of most or all of his profits, while, 
on the other hand, it might fail. Enforced railway com- 
petition has sometimes resulted in kiUing railway enterprise. 
The rise of trusts, pools, and rate agreements is largely 
due to the necessity of protection from competition, pre- 
cisely analogous to the protection given by patents and 
copyrights. 

Combinations are largely the result of the two conditions 
we have been considering — the fact that the supply curve 
descends, and the fact that there is large invested capital. 



332 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVII 

The antitrust movement, in so far as it aims to compel 
competition, does not take these facts into account ; nor does 
it understand the necessities which have led to monopoly. 
So considerable are the lines of business in which either 
there is a large sunk capital or a descending supply curve, 
that if we do not allow some form of trade agreements 
many kinds of trade are to-day practically impossible. 
Restrictive measures should be directed toward the control 
of monopolies and combinations, not to the restoration of 
competition. At the present time the general tendency is 
towards those forms of production in which cutthroat com- 
petition figures and in which monopoly will ultimately 
rule. It must not be supposed, however, that all or even 
most of productive enterprise is of this character. There is 
an immense field in which the older form of competition 
still holds sway ; that is, in which marginal cost increases 
with increased production so that the supply curve is of the 
ascending, not the descending, type. In such cases com- 
petition is still the " life of trade " and affords a safeguard 
for the consumer against exorbitant prices. Such com- 
petition needs no regulation, and in general is better off 
without it. 



CHAPTER XVIII 

MUTUALLY RELATED PRICES 

§ I. Arbitrage 

We have seen how the price of any particular good is 
determined under varying conditions of competition and 
under monopoly. In each case the particular price has been 
considered, quite apart from other prices. We found that 
each price was determined by its own supply and demand. 
But " supply and demand " were expressed by schedules 
(or curves) which in turn depend upon schedules (or curves) 
of desirability which themselves depend on innumerable 
outside conditions — among them being other prices than 
the particular price in question. In fact, we have seen that 
these separate curves are affected by the general level of 
prices. We now have to observe that they are also affected 
by other particular prices. 

In the first place it is evident that the prices of the same 
article in different markets act and react on each other. 
Thus, the price of wheat in Chicago affects the price of wheat 
in New York, Liverpool, and elsewhere. The fact that wheat 
can be transported quickly and cheaply from one market 
to another prevents the possibility of great differences in 
prices. Any considerable difference in prices between two 
markets such as Chicago and New York will soon correct 
itself through the transportation of wheat from the cheaper 
to the dearer market. If all communication between the 
markets could be cut off so as to prevent absolutely such 

333 



334 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

transportation of wheat, the supply and demand schedules 
or curves in each market would be independent of those in 
the other, and the resultant prices in the two would fluctuate 
independently of each other. But, given cheap and rapid 
transportation, the supply and demand in one market will 
closely affect and be affected by the supply and demand in 
the other, and there will be a tendency toward equalization 
of prices. In the two this tendency to equalization works 
itself out chiefly through a special class of men who make 
it their business to watch prices in different markets, en- 
deavoring always to buy in the cheaper and sell in the 
dearer. Such transactions are called arbitrage transactions. 
These men engage in the business of arbitrage in order to 
take advantage of price differences ; and while it is not 
their object or wish to equalize prices (for it is on the in- 
equalities of prices that they live) , nevertheless, to equalize 
prices is the effect of their action. 

Suppose, for instance, that the price of wheat in Chicago 
is 75 cents per bushel and in New York $i a bushel. Such 
a situation offers an opportunity for an arbitrage merchant 
to make money rapidly by buying wheat in Chicago at 75 
cents and selling it in New York at $1 . He therefore appears 
in Chicago on the demand side of the market, being willing 
to take a large amount of wheat at 75 cents per bushel. He 
appears in New York, on the other hand, on the supply side 
of the market, being willing to sell a large amount of wheat 
at $1 per bushel. Thus he increases the demand for wheat 
in Chicago and increases the supply in New York. The 
effect, as we have seen, must be to increase the price in 
Chicago and decrease the price in New York. 

The former may rise from 75 cents to 80 cents per bushel, 
and the latter may fall from $1 to 95 cents per bushel. But, 
even at these prices, the arbitrage merchant will be able to 
reap a rich harvest and will continue to do so until the dif- 
ference in price is sufficiently reduced. Instead of the prices 
remaining 80 cents and 95 cents, they become, let us say, 



Sec. i] mutually RELATED PRICES 335 

82 cents and 93 cents and then 84 cents and 90 cents. This 
leaves the merchant a margin or difference of only 6 cents. 
But as the cost of transporting wheat from Chicago to New 
York is, we shall suppose, about 6 cents per bushel, there 
is no longer profit to the arbitrage merchant, and thus the 
equalization of prices will be limited by the cost of trans- 
portation. The price in New York can never be above 
that in Chicago by more than 6 cents per bushel. For 
similar reasons, the prices in Chicago cannot exceed those 
in New York by more than the cost of transportation; 
otherwise the arbitrage merchant would buy wheat in 
New York and sell it in Chicago. 

It is by such arbitrage transactions that the prices of the 
same commodity in different markets seek a common level, 
just as water flowing from one reservoir to another tends to 
equalize the levels of the two. The more the costs of trans- 
portation are reduced, the more nearly equal will the prices 
of any commodity in different markets become. With 
the progress of civilization, and especially with the improved 
means of transportation by railway and steamships, the 
equaUzation of prices of transportable goods has proceeded 
with great rapidity. The commercial world still consists 
of a number of separate markets, but the communication 
between these markets is becoming constantly more cheap 
and rapid, so that, in a sense, the whole world almost forms 
one great market for certain staples like wheat, other grains, 
and the precious metals. For articles which are difficult of 
transportation, bulky, and otherwise subject to expenses of 
transportation large relatively to their value, the tendency 
to the equalization of prices is less striking. This is partic- 
ularly true of human services by " labor," which can only 
be transported through migration. Nevertheless, there is 
a constant tendency for migration to take place in order 
to take advantage of differences in the price of labor. Both 
the European and Oriental workmen often leave their low 
wages for the higher wages in America or other new countries. 



336 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XVIII 

Before the days of rapid transportation it was not uncom- 
mon for wheat to command famine prices in one country, 
while, at the same time, it was a glut on the market in 
another. 

It is evident that the equalization of prices is an advan- 
tage to the world as a whole, for it is better that there 
should be a moderate supply of wheat, and therefore of 
bread, throughout the world than that there should be in 
some places feast and in others famine. Therefore the 
intercommunication of markets and the resulting equaliza- 
tion of prices must be regarded as an advantage to society. 
It does not follow, however, that it is an advantage to 
every individual in society. 

For instance, when the fertile lands of the Mississippi 
Valley were tapped by building railways from the East, 
the cheap wheat from these lands began to enter the markets 
of the East, where the price of wheat had been relatively 
high. The result was to lower the price of wheat in the East. 
This reduction in price injured the New England farmer. 
Such injury of individuals almost inevitably happens with 
every economic readjustment of conditions. Rapid and 
cheap transportation by connecting all lands and countries 
has, in spite of the general good accomplished for the 
world as a whole, injured great groups of producers by 
subjecting them to competition from which the barriers of 
nature had previously protected them. These producers 
have therefore asked the government to protect them by 
raising artificial barriers in place of the natural barriers 
which have been destroyed, and the protective tariff has 
as its chief source of popularity the fact that it protects 
the local producer of particular articles against the importa- 
tion of such articles from abroad. The policy of protection 
is thus an attempt to interfere with the equalization of 
prices which the improvement in transportation is con- 
stantly producing. 

But just as this progress of equalization of prices creates a 



Sec. i] mutually RELATED PRICES 337 

special injury to some particular producers, it creates special 
benefits to others. The transcontinental railways have not 
only injured the" owners of the rocky farms in New England, 
but have vastly benefited the owners of the alluvial lands in 
the Mississippi Valley ; for they have given them an oppor- 
tunity to sell their products to advantage in the more rocky 
parts of the world. In general we may say that the equal- 
ization of prices constantly going on through improvement 
in transportation facilities injures the producer in those 
regions where prices were previously high, but benefits the 
producer in regions where those prices were previously 
low. The former group have, therefore, an interest in pro- 
tection ; the latter, an interest in freedom of trade : the 
one, an interest which tends to prevent, and the other, an 
interest which tends to promote, the intercommunication 
of markets. Among consumers, on the other hand, opposite 
results ensue. Those particular consumers who were enjoy- 
ing the lowest prices are injured by the rise which equaliza- 
tion brings to them, while those who had to pay high prices 
are benefited by the fall which equalization brings to them. 
In general, the inevitable effect on societ}^ as a whole is a 
gain, for the reason that a larger quantity of goods is 
obtained with a smaller expenditure of effort. It is evi- 
dently more economical for the world to grow its wheat 
in the Mississippi Valley than on the refractory soil of 
New England, and the transportation facilities which have 
brought about this condition have been of the same nature 
as labor-saving machinery. 

It is not within the scope of this book to discuss the argu- 
ment for or against the protective tariff, but the student 
can at this point realize that the movement for protection 
is of the same nature as the movement against labor-saving 
machinery, which is a protest against the cheapening pro- 
cesses which come from inventions, the protest being made 
by the special interests which are injured by the introduction 
of these processes. 



338 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

§ 2. Speculation 

We have spoken of the equaHzation of prices as between 
different places. We have next to consider equaHzation of 
prices as between different times. Corresponding to the 
tendency to the equalization of the prices of a given com- 
modity between different places, that is, between the places 
where it is abundant and cheap and the places where it is 
scarce and dear, there exists a tendency to the equalization 
of the prices of a given commodity at different times. More- 
over, the method of equalization of prices between times 
corresponds somewhat to the method of equalization of 
prices between different places. Just as the equalization 
between places is accomplished by the transportation of 
commodities, so the equalization between times is accom- 
plished by keeping the commodity from the time when 
it is abundant, and therefore cheap, to the time when it is 
scarce, and therefore dear. For instance, ice is abundant 
and cheap in winter, but scarce and dear in summer. Con- 
sequently much of it is stored in ice houses in winter and 
kept for use in the summer ; that is, the part which is thus 
stored is subtracted from the winter supply and added to 
the summer supply. The effect tends to equalize the prices 
of ice at different seasons. In the same way many vege- 
tables and fruits, such as potatoes and apples, which are 
abundant and cheap in the summer and fall, are to a large 
extent stored for use in winter when they will be scarce and 
dear. The effect is to subtract a certain quantity from use 
in the summer and fall and to add to the amount used in 
the winter. 

Just as the equalization of prices between places is largely 
due to the work of a special class of business men who engage 
in arbitrage transactions, so the equaHzation of prices be- 
tween different times is largely accomplished by a special 
class called speculators. A wheat speculator, for instance, 
withdraws wheat from the market when it is abundant and 



Sec. 2] MUTUALLY RELATED PRICES 339 

cheap, and supplies it when it is scarce and dear. At the 
former times he appears on the demand side of the market 
as a wheat buyer ; at the latter he appears on the supply 
side as a seller. By adding to the demand when the price 
is low, he tends to raise prices, and by adding to the supply 
when the price is high, he tends to lower prices, thus acting 
as an equalizing agent. 

We need to distinguish two chief kinds of speculation 
according as the price of the given commodity is expected to 
rise or fall. Speculators who try to profit by any expected 
rise of price are called " bulls." Their operations consist 
simply in buying wheat in the present, keeping it until the 
future, and then selling it again at higher prices. Specu- 
lators, on the other hand, who try to benefit by an ex- 
pected fall in prices are called " bears." Their operations 
are somewhat more complicated. It is easy to decrease the 
present consumption of any commodity and increase corre- 
spondingly future consumption, i.e., to withdraw certain 
stocks and hold them until the future. But when the 
reverse operation is needed, namely, to increase present 
consumption at the expense of future, the operation is more 
difficult. We cannot lay hold of a future stock of wheat 
before it exists. The best we can do is to use up our 
present wheat as completely as possible. This is what is 
needed when prices are falling. Speculators will then add to 
the present supply by selling out any stocks from previous 
holdings. They and all who deal in wheat will refrain as far 
as possible from intentionally carrying over any of the pres- 
ent stock of wheat into the period when they expect it to be 
abundant, and therefore cheap. But this is not all ; the 
speculators will also speculate for a fall by " selling future 
wheat short." This operation of "selling short" consists 
in agreeing to sell wheat in advance of the time of delivery, 
depending on its expected fall in price to enable them to se- 
cure the wheat in time to fulfill their contracts. It is called 
" selHng short," because the speculators are selling some- 



340 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

thing which they do not yet possess, i.e., of which they are 
" short." The speculator who sells short hopes to make a 
profit by buying at a lower price than the price at which 
he sells short. If, for instance, in January the price of 
wheat is high, say $i a bushel, he sells July wheat, that 
is, wheat deliverable in July, at 90 cents a bushel. This is 
because he expects that when July comes, wheat will be 
worth less than 90 cents a bushel, say 85 cents, so that 
he can buy it for 85 cents and sell it immediately to his 
customer for the 90 cents previously agreed upon. 

The effect of selling wheat short is to encourage still 
further the using up of present suppHes, the speculator thus 
guaranteeing the delivery of wheat to those who buy of 
him so that these persons will not need to accumulate the 
wheat in advance for themselves. Of course, the speculator 
must take good care that the wheat is available at the time 
agreed, but, being presumably an expert as to the conditions 
of wheat supply, he can manage to get the wheat in the nick 
of time or, at any rate, with less preliminary accumulation 
than those who are not experts. The effect is therefore to 
obviate the necessity of any one's keeping wastefully on hand 
any large stock. Where such a speculative market exists, a 
miller can, when wheat is scarce, use up his existing stock 
without replenishing it until the last minute, at which time 
he has the assurance of those who have sold him wheat short 
that the wheat will be on hand. Without such assurance 
from experts in wheat speculation, the miller would have 
feared to have run his stock so low and would have laid in 
wheat in advance even at high prices. He defers his stock- 
ing up by means of the short selling of wheat to him by the 
speculator. 

In the same way a woolen manufacturer is enabled in 
a speculative market to lay in his supply of wool in the 
most advantageous manner. If the price of wool is fall- 
ing, he will wait before stocking up, merely contracting 
in advance with a speculator for the immediate delivery of 



Sec. 2] MUTUALLY RELATED PRICES 34 1 

new wool, when his present stock is exhausted. In the same 
way builders use the speculative market to assure them- 
selves of building materials when needed. The builder 
arranges in advance with dealers in buUding materials 
for the delivery to him of the lumber, bricks, and stones 
needed. By thus selling short or making contracts for 
deHvery in advance of possession, and sometimes even 
in advance of the actual existence of the commodity 
sold, there is a great saving accomplished in the stocks 
which need to be carried. Without such selling of futures 
the miller, the woolen manufacturer, the builder, and 
great classes of merchants would be under the necessity 
of carrying far larger stocks than they now carry. In 
other words, the speculative operation known as selling 
short enables the community to economize its capital exist- 
ing in the form of accumulated stocks of goods, especially 
at times when these goods are scarce and dear and most 
need to be economized. This selling short has the effect of 
deferring the demand for a commodity. The miller, the 
woolen manufacturer, the builder, and all others who buy 
futures — the wheat, the wool, the building materials, etc. — 
do so instead of buying present wheat, wool, building mate- 
rials, etc. The fact that they find a speculative market in 
which they can buy futures has therefore, as its effect, less 
buying in the present. In other words, it reduces the pres- 
ent demand, and therefore reduces the present price, while 
it increases the future demand and the future price. Thus 
it tends to reduce the gap between the present high prices 
and the future low prices. 

But while speculation normally tends to mitigate either 
an impending rise or fall of prices, its power to do so is 
limited, just as is the power of equalizing prices among dif- 
ferent places by arbitrage. The latter operation does not 
pay when the difference in price is reduced to the cost of 
transporting from place to place. Likewise speculation 
does not pay when the expected difference in price becomes 



342 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

too small. One of the costs to the speculator for a rise is 
interest on the capital he locks up when he withdraws a 
commodity from the market and holds it for a certain period. 
Suppose, for instance, that he borrows mone}^ in order to 
speculate for a rise. The anticipated rise must be sufficient 
to cover the interest he pays and all the other costs involved 
in the operation. Otherwise the speculation promises a 
loss instead of a gain. Likewise, if he is to speculate for 
a fall, he must anticipate a fall sufficiently below the price 
at which he sells short to enable him to make a profit. 
Speculation, therefore, is a function in equalizing prices 
between times, very analogous to the function of arbitrage 
transactions in equalizing prices between different places. 
But there is one important distinction between speculation 
and arbitrage. Speculation, by the nature of the case, in- 
volves uncertainty in a far greater degree than arbitrage. 
The prices among different places can easily be known, but 
the prices between different times are far more difficult to 
know, for the future is always uncertain. All we can do is 
to predict according to the best information we can get. It 
therefore often happens that the speculator makes a mistake 
in his forecast of the future. He may believe that prices 
are going to rise when they are going to fall, or to fall when 
they are going to rise If, acting on a mistaken belief that 
prices are rising, he holds wheat for a rise, the result of his 
action will be to aggravate the fall ; for buying in the present 
will raise prices now when they are already high, and selling 
in the future will lower them then when they will be low. 
In like manner, if he makes the mistake of selling short when 
prices are rising, he will aggravate the rise, for he will lower 
the prices in the present when prices are already low and 
raise them in the future when they are already high. 

Therefore speculation may do either good or harm. It 
does good when it reduces the inequality of prices at different 
times. It does harm when it aggravates this inequality. 
Fortunately, the interests of the speculator and the public 



Sec. 2] MUTUALLY RELATED PRICES 343 

are to a large extent identical. It is evident that when the 
speculator is correct in his prognostications, he will make 
a profit. His object is to make a profit when prices are rising, 
but he can do so only by mitigating the rise. Likewise his 
object is to make a profit when prices are falling, but he can 
do so only by mitigating the fall. His profits are, as it were, 
a reward paid him by the community for mitigating price 
changes. If he makes a mistake in either form of specula- 
tion, he suffers losses, and these losses may be regarded as 
a sort of penalty he suffers for aggravating the inequalities 
in prices. Since the interests of the speculator and of the 
public are thus parallel, there is a premium put on wise and 
beneficial speculation and a penalty on unwise and injurious 
speculation. 

It is unfortunately true, however, that in spite of the 
penalties for unwise and injurious speculation, much specu- 
lation is of this character. This is largely due to the fact 
that many engage in speculation who have no adequate 
equipment for so doing and no independent judgment as to 
the causes making for a rise or a fall in prices. The ultimate 
justification for speculation must rest in the wisdom and 
independence of those who speculate. Speculation which 
merely follows a " tip " has no independent value. If 
every person who speculates for a rise or a fall should do so 
on a basis of his own best independent judgment, the chances 
are that mistakes of those who are overconfident in either 
direction would largely offset each other. 

During recent years the general public have been beguiled 
into the folly of entering the speculative market, but the 
public have no special knowledge of market conditions, and 
their participation in speculation is almost as apt to 
aggravate as to alleviate the inequalities in prices. In such 
cases speculation becomes mere gambling. In fact, it is 
worse than gambling, for the evils are more extensive, being 
shared by the consumers and producers and all who are 
affected by the price fluctuations thus caused. Such evils of 



344 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

speculation are especially grave when, as usually happens, 
the general public speculate in a mass, i.e., all in the same 
direction. Like sheep, they tend to follow the same 
leader, and the great bulk of their mistakes are apt to be in 
the same direction, first in one direction and then in the 
other. The effect of their movements is Hke that of a 
sudden rush of the passengers of a ferryboat first to one 
side and then to the other, — it may cause a capsize. 

We see, then, that the chief evils of speculation are largely 
the work of the unprofessional speculators, just as the chief 
evils of reckless automobile driving are due to untrained 
chauffeurs. It must not be supposed, however, that the 
professional speculator is always a pubHc benefactor. Not 
only may he also make mistakes which cost him and 
society dear, but he may sometimes "rig the market" and 
manipulate prices. When a professional speculator merely 
attempts to take advantage of an impending rise or fall of 
prices, he is usually a public benefactor; but when he 
attempts to create the rise or fall, of which he is to take 
advantage, by false reports, by "cornering," or by other 
means, he is apt to be a mischief-maker. 

This is not the place, however, to discuss the benefits and 
evils of speculation further than to warn the student against 
the wholesale condemnation of speculation so common in the 
public press. Like most other industrial operations, specula- 
tion may be either good or bad. So far as it is good or bad, 
the discussion of the two belongs to applied economics. Our 
object here is to show that speculation, so far as it is good, 
tends to equalize prices in time. 

§ 3. Prices of Goods which Compete on the Demand Side 

As a result of our study of arbitrage and of speculation, 
we see that the price of any particular commodity at any 
time and place, though directly fixed by its supply and de- 
mand at that time and place, is indirectly affected by the 



Sec. 3] MUTUALLY RELATED PRICES 345 

supply and demand at other times and places; for these 
react upon supply and demand at the particular time and 
place under consideration. The price of wheat in Chicago 
on January i, 191 2, is determined by the intersection of the 
supply and demand curves in Chicago on that date; but 
those supply and demand curves depend, as we now see, upon 
the price of wheat in St. Louis, New York, Liverpool, and 
other places, and depend likewise on the prices of wheat 
on dates before and after January first. The price of 
wheat in Chicago on January first tends to be close to 
the price of wheat in neighboring places and at neighbor- 
ing times. 

Not only does the supply and demand of wheat at any 
time or place depend upon the price of wheat at other times 
and places, but it depends likewise on the prices of other 
things than wheat. In particular the price of wheat de- 
pends on the prices of substitutes for wheat. Substitutes for 
wheat will resemble wheat in affecting the price of wheat, 
but the effect will not be so direct if the substitutes are only 
substitutes on one side of the market ; for instance, if they 
are Hke wheat so far as the use to the consumer is concerned, 
but unlike wheat so far as the cost to the producer is con- 
cerned. Thus sugar and honey are substitutes for each 
other to the consumer, for they serve similar needs so far 
as the consumer is concerned, though on the supply side 
they are produced in totally different ways. 

Two sorts of wealth are said to be substitutes on the de- 
mand side when they fill similar needs. It follows that the 
satisfaction of needs by one of the two substitutes not only 
reduces its marginal desirability, but affects the marginal 
desirabihty of the other in a similar fashion. Consequently, 
the marginal desirabihties of the two tend to fall or rise in 
unison. Therefore also the prices of the two tend to fall or 
rise in unison. It is evident, for instance, that the price 
of coal will affect the demand for coke, since coal and coke 
are often substitutes, or competing articles. The more 



346 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XVIII 

nearly either of the two articles comes to filling the ofl&ce 
of the other, the more closely do their prices keep pace 
with each other. If two articles are absolutely perfect 
substitutes, they are, to aU intents and purposes, the same 
article, and have the same price. 

There is scarcely an article which does not have its sub- 
stitutes. The two fuel substitutes, coal and coke, include 
numerous subclasses and varieties, such as anthracite and 
bituminous coal. Other fuel substitutes are wood, petro- 
leum, gasoline, alcohol, and gas. A change in the price of 
any one of these tends to produce a similar change in the 
prices of the rest. Likewise the prices of food substitutes 
are sympathetic among themselves — the prices of such sub- 
stitutes as wheat, corn, oats, rice, and barley ; of fish, meat, 
and fowl ; of the various fruits and the various vegetables. 
Similar sympathetic relations exist among clothing sub- 
stitutes, such as woolen, cotton, linen, and silk ; or among 
ornamental substitutes, such as diamonds, pearls, rubies, and 
amethysts. 

The closest substitutes, though still sufficiently distin- 
guishable to prevent their being quite classed as the same 
article, are the various " quaHties," " grades," or " brands " 
of any particular class of articles. The various breakfast 
foods prepared from wheat are close substitutes. There 
are many grades of wheat, of sugar, of coffee, of meat, of silk, 
and, in fact, of almost any class of articles which can be named. 
Among different grades the prices are usually so closely paral- 
lel that trade journals often give the price of one staple grade 
only — as of a standard grade of coffee — leaving it to the 
reader to infer what the prices of the other grades must be. 
But the prices of different qualities of any good, though 
they rise and fall together, may be wide apart among them- 
selves. Various qualities of land, for instance, bring very 
different prices, ranging from almost nothing to thousands 
of dollars per square foot. When the various "quaHties" 
yield precisely the same sort of benefit, the only differences 



Sec. 4] MUTUALLY RELATED PRICES 347 

among them are differences in the quantities of benefits 
which flow from them. In this case the prices of the goods 
will evidently be proportioned to the net benefits they yield. 
Wheat lands, for instance, of different fertility, will be worth 
prices proportioned to the net value of wheat which they 
yield. 

§ 4. Prices of Goods which are Complementary on 
the Demand Side 

Substitutes may be said to compete with each other. We 
now consider articles which complete each other or, in 
other words, are complementary. Complementary articles 
jointly serve the same want. We have seen that of two 
substitutes one is used instead of the other for a given pur- 
pose. But of two complementary articles one is used in 
conjunction with the other for a given purpose. Horses and 
mules are substitutes, so far as either may be used for 
the purpose of drawing loads. A horse and a cart are 
complementary, for this same purpose. 

We have seen that the essential attribute of substitutes 
is the tendency of their marginal desirabilities to keep 
pace with each other, and the consequent tendency of their 
prices to correspond. In the case of complementary articles 
it is the quantities of the articles which tend to maintain 
a constant ratio. In the case of perfect substitutes the ratio 
of their prices is absolutely constant. In the case of perfect 
complementary articles it is the ratio of the units used that 
is absolutely constant. Table knives and forks are practi- 
cally perfect complementary articles, as are cups and saucers 
or " hooks " and " eyes." A " hook " without an " eye " 
is of little or no use and the number of " hooks" and the 
number of " eyes " will always be substantially equal. 
The prices of two substitutes tend to move sympathetically, 
but the prices of two complementary articles tend to move 
inversely. If horses are abundant, and therefore cheap, 



348 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

the tendency is to make mules, which are a substitute, cheap 
also, but to make the complementary carts dear; for the 
more horses used, the more carts will be needed, and the 
increased demand for them will tend to raise the price. 

Articles which are related to each other in this comple- 
mentary fashion are almost as common as those which are 
related to each other in competitive fashion. Various articles 
of food are used in combination, as, for instance, bread and 
butter, or the elements of which a sandwich is composed. 
A daily diet is usually constructed with regard to the fitting 
together of the different courses served, and of the meals 
as a whole. Similarly, the various parts of one's wardrobe 
are arranged with reference to one another ; and again, a 
dwelling and its various furnishings are mutually adapted. 
The tables and chairs, crockery, knives and forks, beds 
and bedding, rugs and wall paper, are severally arranged in 
relation to one another in their respective groups, and to the 
house to which they all constitute a complement. 

^ 5. Similar Relations on the Supply Side 

Thus far we have considered only goods which compete 
with each other, or complete each other, in respect to 
demand. Turning now to the supply side of the market, 
we find similar relations. 

Two goods compete in supply when they occasion similar 
efforts or costs to those who sell them. Thus, hay and 
wheat — though far from being substitutes on the demand 
side, satisfying dissimilar wants — are to some extent sub- 
stitutes on the supply side, for they require similar costs. 
Both require the use of farm land and the labor of mowing 
or reaping. The prices of such articles competing in supply, 
like those of articles competing in demand, tend to rise 
or fall together because their costs tend to rise or fall 
together. The best example of competition of costs is 
found in the services of laborers. The wages, or the pric6s 



Sec. s] mutually RELATED PRICES 349 

paid for various kinds of work, tend to keep pace with each 
other, Man is so versatile a machine that one kind of 
workman can readily substitute for another. On a pinch, 
the same man may be a factory employee, a farm hand, a 
coachman, carpenter, mason, plumber, or clerk. Conse- 
quently, these various sorts of work, though filling very 
unlike wants on the demand side, compete on the supply 
side, and tend to bear similar prices. If the wages of clerks 
rise, the wages of carpenters will rise also, because otherwise 
many carpenters would want to become clerks. The con- 
sequence is that wages of all sorts usually rise or fall 
together. If labor of all kinds could be perfectly sub- 
stituted, wages of all kinds would remain in absolutely fixed 
ratios to each other, i.e., would rise or fall together in exactly 
the same ratios. Such " perfect mobility of labor," however, 
never exists. On the contrary, labor may be classified 
into several more or less " noncompeting groups," such as 
brain work, skilled work, and unskilled work. 

Two goods complete each other in supply, or are comple- 
mentary on the supply side, when jointly they involve 
the same cost, i.e., when the supply of one tends to carry 
with it the supply of the other. The less important of the 
two is then called the by-product of the other. Tallow 
is a by-product of beef and hides. Other examples of 
articles completing each other in supply are mutton and 
wool ; coal, coke, and gas. 

The prices of two completing goods on the supply side 
tend to move in opposite directions, just as we saw was 
the case on the other side of the market. Consider, for 
instance, beef and hides. If the price of beef rises, the 
amount supplied at the higher price will increase. Hence 
the supply of hides will be increased at the same time. Con- 
sequently their price will fall. 

We see, therefore, that two articles may be substitutes 
on the demand side by replacing each other in satisfying 
the same sort of desires, or on the supply side by requiring 



350 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

the same sort of costs; and also that they may be com- 
plementary on the demand side by jointly satisfying the 
same desire, or on the supply side by jointly requiring the 
same costs. 

§ 6. Prices of Goods in Series 

In all the cases thus far considered, the relationship 
between articles is on the same side of the market. We next 
proceed to consider goods, the relation between which in- 
volves both sides of the market. 

The supply of one article may have relationship to the 
demand of another. This is true of two articles, one of 
which is used in producing the other. Such goods may 
be called goods " in series," because one follows after 
the other in the process of manufacture. In this respect 
their relationship differs from the others discussed. Sub- 
stitutes or complementary articles are, as it were, " abreast" 
of each other on the same side of the market, whereas 
wool and woolen cloth, for instance, "go tandem" on 
opposite sides of the market. Wool is used (as raw material) 
in producing woolen cloth. Hence the prices of wool and 
woolen cloth are intimately related to each other. The 
relation, however, is different from those relations hitherto 
considered. Wool and woolen cloth are neither substitutes 
nor complementary goods on the same side of the market. 
Their relation consists in the fact that the producers or sellers 
of woolen cloth are the consumers or buyers of wool. Both 
the demand and the supply side are involved. Certain 
people demand wool in order to supply woolen cloth. 

The prices of goods in series move in sympathy. It is 
evident, for instance, that given a high price for wool, the 
prices in the supply schedule (or curve) for woolen cloth 
will be higher than otherwise, and as a consequence the 
market price of woolen cloth will rise. Conversely, given 
a high price for woolen cloth, the prices in the demand 



Sec. 7] MUTUALLY RELATED PRICES 351 

schedule (or curve) for wool will be higher than otherwise, 
and as a consequence the market price of wool will rise. 
Thus, any change in price of either of these two articles 
will tend, sooner or later, to make the price of the other move 
in the same direction. 

In the same way cotton and cotton cloth are goods 
in series, and their prices are likely to move in sympathy 
with each other ; Hkewise the prices of wood and houses, of 
wheat, flour, and bread; or of iron mines, iron ore, pig 
iron, rolled iron, steel, steel rails, and railways. This 
chainlike or serial relationship comprises many other ele- 
ments than raw materials and finished products. Thus, 
steel is related to the labor and coal consumed in its manu- 
facture in much the same way as it is to the iron ore out of 
which it is wrought. The price of steel therefore moves in 
sympathy not only with the price of iron, but with that of 
coal and labor as well and of all the other goods employed 
in its production. The series or chain of goods is the chain 
of productive processes already discussed under the head 
of successive interactions. 

§ 7. Efforts and Satisfactions the Ultimate Factors 

This serial relationship enables us to see clearly the fact 
that, at bottom, supply rests on efforts, and demand on 
satisfactions. We have seen in economic accounting that 
all items of income and outgo cancel among themselves, 
except efforts and satisfactions. We now see this same 
truth in its application to supply and demand. As simple 
as this truth is, it is commonly overlooked, because people 
are blinded by the all-pervading presence of money receipts 
and expenses. The business man, reckoning in money, 
comes to think of money expenses and money receipts as 
though they were real costs and benefits in the productive 
process, whereas they are only the representatives of real 
costs (efforts) and real benefits (satisfactions). We disen- 



352 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XVIII 

tangle ourselves from the meshes of this money snare when 
we see that the controlling factors in determining prices are 
satisfactions on the demand side and efforts on the supply 
side. Between efforts and satisfactions there may be in- 
numerable intermediate stages, at each one of which supply 
and demand result in a market price ; but each such price 
represents simply anticipated satisfactions or efforts trans- 
lated into money valuations. Any dealer at intermediate 
stages, between efforts preceding him and satisfactions fol- 
lowing after, has but little independent influence on price. 
He is like a link in a chain or a cogwheel in a machine, 
merely receiving and transmitting. If some real cost of 
production earlier in the chain, i.e., some effort (labor), 
is saved, he receives the cheapening effect from those of 
whom he buys, and passes it on to those to whom he sells. 
If some real benefit is reduced, i.e., some satisfaction di 
minished, as by a change of fashion, he receives the cheapen- 
ing effect from those to whom he sells, and passes it back 
to those from whom he buys. The supply and demand of 
wheat in the Chicago wheat pit, for instance, is chiefly 
dependent on the labor of growing wheat and the satisfaction 
of eating bread. If a new labor-saving reaping machine 
is devised which reduces the actual effort of producing 
wheat, the effect is soon felt by the Chicago wheat dealer and 
transmitted to his customer. Or if people turn to a rice 
diet and no longer care much for bread, this effect is also 
soon felt by the Chicago dealer and passed back to the 
wheat producer. 

An intermediate dealer may not know the ultimate causes 
of the changes in supply and demand which affect his business 
on either side, and sometimes he does not try to think beyond 
what he immediately observes. Wholesale merchants gen- 
erally offer to their customers, the retailers, as an expla- 
nation of the rise in their charges, the fact that they have 
to pay higher prices to the jobber ; or, again, they may offer 
to the jobber as an explanation of the fact that they cannot 



Sec. 7] MUTUALLY RELATED PRICES 353 

pay as much as before, the fact that they cannot get as 
much from the retailers. Any such explanation of prices is 
shallow, for it goes no farther than explaining one price 
by another in the next link in the chain of prices. 

We see, then, that everything intermediate which happens 
in the economic machinery represents merely steps in the 
connection between effort and satisfaction. When Robinson 
Crusoe supplied his wants, there was a direct connection 
between his efforts in picking berries, for instance, and the 
satisfaction of eating them. To-day there are a number of 
links between these, but the same principle still applies. 
Supply and demand at intermediate points merely reflect 
final efforts and satisfactions. 



CHAPTER XrX 

INTEREST AND MONEY 

§ I. The Importance of Interest 

We have seen that, in the last analysis, prices depend on 
comparisons between satisfactions, or efforts, or both. But, 
since these satisfactions and efforts are not all simultaneous, 
but are distributed in time, their comparison requires us to 
take account of interest. Consequently our study of prices 
will not be complete without a study of the rate of interest. 
It is only by means of the rate of interest, explicitly or 
impHcitly employed, that the prices of most goods are 
reckoned. The rate of interest, as previously explained 
(Chapter VI, § i), is itself a sort of price. So far as it has 
been used in Chapter VI and elsewhere for capitalizing 
income, it was taken ready made just as all prices were 
taken ready made. We are now about to inquire how this 
peculiarly important price, called the rate of interest, is 
actually determined, just as we have already inquired how 
other prices are determined. And it is by far the most 
important sort of price with which economics has to deal. 

Most people have an idea that the rate of interest is a 
technical Wall Street phenomenon, concerning nobody ex- 
cept money lenders or borrowers. This is partially true of 
explicit or contract interest. But there is impHcit interest 
to be considered. An explicit rate of interest is the rate 
of interest explicitly stated in a contract. An impHcit rate 
of interest is the rate of interest which an investor expects 
to reahze who makes sacrifices at one time for the sake of 
compensating benefits at a later time. Implicit interest 
is also called profits. As was shown in Chapter VI, if we 

354 



Sec. i] interest AND MONEY 355 

invest in a bond, the price that we pay carries with it the 
implication of a rate of interest we expect to realize on 
the investment. The implicit rate of interest, or the rate 
which we realize, is that rate of interest which, when used 
for discounting the income of the bond, will give the price 
at which we bought the bond. For instance, if a bond 
yielding $5 a year for 10 years, and then redeemable for 
$100, sells now for $102, we know that the rate of interest 
realized is not five per cent, as it would be if it sold at par. 
It is less than five per cent — about 4.8 per cent (see 
Chapter VI, §4). The implicit rate of interest we realize 
on such a bond may be found, as we have already seen, 
from a mathematical table. The man who buys the bond 
mentioned receives 4.8 per cent interest on his investment 
just as truly as though he had lent out his $102 at that 
rate. In fact, to buy a bond of a corporation or a 
government is often spoken of as " lending money " to 
that corporation or government. Again the buyer of 
land who pays "twenty years' purchase" (for instance, 
$20,000 for land from which he expects an annual 
rental of $1000) is making five per cent just as though 
he were lending out his $20,000 at that rate. In the 
same way a man who buys stock realizes a certain rate per 
cent on his investment just as if he were lending money 
at interest. Similarly the purchaser of a house gets a 
return on the money he spent for it quite analogous to 
the return he would have received had he lent that 
money. 

In short, every investment is analogous to a loan and 
involves a rate of interest on the purchase price just as 
truly as does the loan. As every purchase is really an 
investment of present money for future benefits in money 
or measurable in money, every purchase price implies a 
rate of interest. A man cannot even buy a piano or an 
overcoat or a hat without virtually discounting the value of 
the uses which he expects to make of that particular article. 



356 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XIX 

The rate of interest, then, is not confined to Wall Street, 
but is something that touches the daily life of us all. 

How, then, is this important magnitude, the rate of 
interest, determined? The problem of interest is one of 
the most perplexing problems with which economic science 
has had to deal, and for two thousand years people have 
been trying to solve the riddle. 

§ 2. A Common Money Fallacy 

Among the earliest explanations of the rate of interest 
was that it is a payment simply for money, and that con- 
sequently it depends upon the quantity of money on the 
market. We commonly speak of interest as the "price of 
money," and the trade journals tell us that "money is 
easy" in Wall Street, meaning that interest is low, or that 
it is easy to borrow money. Or we are told that " the 
money market is tight," meaning that it is hard to borrow 
money. We often hear the argument that the present 
high cost of living cannot be due to any plentifulness of 
money, because, if money were really plentiful, it would 
be cheap, meaning that the rate of interest would be low. 
Probably the great majority of unthinking business men 
believe that interest is low when money is plentiful, and 
high when money is scarce. 

This view, however, is fallacious, and the fallacy consists 
in forgetting that plentiful money ultimately raises the 
demand for loans just as much as it raises the supply, 
and therefore has just as much tendency to raise interest 
as to lower it. Suppose, for instance, a piano dealer wishes 
to stock up his store with pianos (the price of pianos being 
$200 apiece), and that he wishes to have a stock of 50 
pianos in his salesroom. To accomplish this he evidently 
will have to borrow $10,000. He goes to the bank and 
borrows it. Now, let us suppose that money becomes twice 
as abundant. This man, wanting to borrow again, will have 



Sec. 2] INTEREST AND MONEY 357 

an idea that in some way he will this time get a lower rate 
of interest at the bank, because, he reasons, the bank will 
have more money in its vaults and will be more anxious 
to lend it out. What he forgets is that the result of the 
very abundance of money will be that prices in general 
will rise, and presumably the price of pianos in particular 
will rise ; therefore, in order to get 50 pianos, he will have 
to borrow twice as much money to enable him to pay for 
his pianos at the doubled prices. In order to buy 50 pianos, 
he will need $20,000 instead of $10,000. Likewise every 
other borrowing tradesman will need to borrow twice as 
much to conduct the same business. The fact that the 
banker has twice as much to lend is therefore completely 
offset by the fact that the borrowers will want to borrow 
twice as much. The consequence is that, in the end, 
doubling the amount of money will not affect the rate of 
interest. It will simply affect the amount of money lent 
and borrowed. 

We must remember that interest is not only the price 
of money, but it is the price in money. Interest is unlike 
any other price in that it is the price of money, but it 
is like all other prices in that it is the price in money. 
Thus the rate of interest is found by dividing, say, the 
$5 paid per year by the $100 cash for which it is paid. 
Both the numerator and the denominator of this fraction 
are expressed in terms of money. If we pay attention only 
to the denominator, we are apt to think that an increased 
supply of money should decrease the rate of interest. But 
if we are to have a one-sided view, we might just as well fix 
our attention only on the numerator, and maintain that an 
increased quantity of money, instead of decreasing the rate 
of interest, ought to increase it. The truth is, inflation of 
money ultimately works equally on both sides. In mechan- 
ics one of the first things we learn is that a man cannot 
raise himself by pulling up on his boot straps. The reason 
is that he is pulHng himself down as much as up. The in- 



358 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIX 

flation of the currency pulls interest up on the demand side 
as hard as it pulls it down on the supply side. 

We should beware of the phrase " the price of money," 
for it has two meanings. It may mean the rate of interest, 
which is a ratio of exchange between two moneys — the 
price of money-capital in terms of money-income; or it 
may mean the purchasing power of money over other goods 
— the amount of other goods for which a given amount of 
money can be exchanged. The abundance of money will, 
as we have seen, reduce its price in the sense of purchasing 
power over goods, but it need not on that account reduce 
its price in the sense of the rate of interest. Yet the idea 
that the plentifulness of money tends to make interest 
low is a persistent one among business men. 

One reason for this idea is that bankers usually look upon 
money in relation to their reserves, and if bank reserves 
are low, they have to raise the rate of interest to " protect " 
those reserves. If the reserves are abundant, bankers 
reduce the rate of interest in order to get rid of the reserves. 
The banker is constantly watching his reserve, and has to 
adjust the rate of interest with respect thereto. One 
way to get rid of a plethora of money in the reserve is to 
lower the rate of interest, and one way to protect a de- 
pleted reserve is to raise the rate of interest. But the banker 
should not measure the amount of money circulating 
outside by the amount of money inside the bank vaults. 
What he forgets is that a larger reserve in his vaults does 
not necessarily mean more plentiful money in the country ; 
nor when we have, as at present, for instance, a great 
quantity of money throughout the world, does this fact 
necessarily imply that Banker Smith will have more gold 
in his vaults. The money may get into the pockets of 
people first ; it may in that way raise prices so high that 
the borrowers at banks may demand, for the reasons ex- 
plained, larger loans. And yet, if for some reason a due 
share of the money has not at the start flowed into the 



Sec. 3] INTEREST AND MONEY 359 

banks, the result will be that Banker Smith will, for a time, 
have too little reserve in relation to the greater loans that 
are now demanded of him. The consequence, then, will 
be actually to raise the rate of interest. When, therefore, 
the banker says that more money lowers the bank rate 
of interest, he ought to say, " When bank reserves get an 
undue fraction of money, the bank rate of interest will 
be low ; but when an undue fraction goes into circulation 
outside of banks, the rate will be high." In other words, 
an increase of money will operate in two different ways, 
according to where it happens to go first. Normally and 
eventually, as we have seen in a previous chapter, an in- 
crease of money distributes itself between pockets, tills, 
and bank reserves, so as not to disturb the normal ratios 
between them. When this happens, the rate of interest 
will not be affected at all. 

This conclusion is not based merely on theory. As a 
matter of statistical fact, the rate of interest does not go 
up when money is scarce and down when money is abundant. 
For instance, an examination of the figures for per capita 
circulation of money in the United States for thirty-five 
years shows that in about half of the cases, when money grows 
more abundant, interest is higher, and in half of the cases 
it is lower. In other words, interest changes with abso- 
lutely no relation to the quantity of money in circulation. 

§ 3. Effect during Appreciation or Depreciation 

We conclude, then, that an inflation of the currency does 
not affect the rate of interest, provided, however, the inflation 
affects the loan at the time the loan is made just as much as 
it affects the repayment at the time the repayment is made. 
But the loan and the repayment do not occur at the same 
time; there is an interval of time between them, and it 
may be that the degree of inflation is greater or less at 
the end than at the beginning of this period, in which 



360 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XIX 

case the change in the inflation may, through its effect 
on the values borrowed and repaid, affect the rate of interest 
during the process of change. While inflation is taking place 
there is an effect on the rate of interest, because the effect 
of inflation on the sum loaned is different from the effect 
on the sum repaid. 

This brings us back to the consideration of the transition 
periods of rising and falling prices and discloses a phenome- 
non which we were not ready to discuss in Chapter X, This 
phenomenon is that the rate of interest tends to be high 
during a transition period when prices are rising from one 
level to a higher level and, reversely, that it tends to be low 
while prices are falling from one level to another. Suppose, 
for instance, that prices are rising at the rate of one per cent 
per annum. Then $100 lent to-day is equivalent in pur- 
chasing power, not to |ioo repayable next year, but to $101 
repayable next year. If prices had not risen, the borrower, 
when he paid back his principal of $100, would be 
paying back the same amount of goods as were repre- 
sented by the $100 when he borrowed it. In terms of 
goods he would have been in the same position at the 
end as at the beginning, and so would the lender. But we 
are supposing that prices are rising. Then the lender, when 
he gets back his principal of $100, does not get back as 
much purchasing power as he lent, and the borrower does 
not pay back as much purchasing power as he borrowed. 
In other words, the fact that prices have risen during the year 
has made things easier for the borrower and harder for the 
lender. During the Civil War the United States govern- 
ment issued a great many " greenbacks." The result was 
an inflation of the currency and a consequent rise of prices, 
and the result of that was that men who had mortgaged 
their farms in the West found it very easy to pay back 
their loans. As they said, the mortgages on their farms 
"disappeared like smoke." Five thousand dollars paid 
back in 1864 for $5000 loaned in i860 really represented only 



Sec. 3] INTEREST AND MONEY 36 1 

half as much purchasing power over goods, for prices had 
doubled ; the inflation of the currency freed the borrowers 
from half theirdebts. 

We see, then, that when prices are rising, the principal 
of a debt becomes less and less valuable. If prices are rising 
one per cent per annum, that is, if the principal of the 
debt, in terms of goods, is falling about one per cent, then 
the interest on the debt ought to be increased about one 
per cent in order that there should be the same burden 
on the borrower as there would have been if prices had 
not risen. If prices are rising two per cent per annum, 
two per cent would have to be added to the rate of in- 
terest in order to compensate for the rise ; and so on for 
other rates of rise in prices. On the other hand, if prices 
are falling, we must reduce the rate of interest to offset 
the appreciation of the principal. 

This ideal compensation in the rate of interest would oc- 
cur if man's foresight were perfect. If we knew absolutely, 
for instance, that next year's prices were going to be two 
per cent higher than this year's, the rate of interest might 
be two per cent greater than otherwise. So also, if we 
knew absolutely that all prices would be one per cent less a 
year from to-day, than to-day, the rate of interest during the 
year might be, on that account, one per cent less than other- 
wise. As a matter of fact, an approximation at such ad- 
justment does actually occur. A study of the periods of 
rising and falling prices in the United States, England, 
Germany, France, China, Japan, and India shows that, in 
general, when prices are rising, the rate of interest is high, 
and when prices are falling, it is low. But the adjust- 
ment is never perfect. Men never know the future exactly ; 
they can only guess. People are apparently reluctant to 
believe that prices are going to change very much in either 
direction. The result of this inadequacy of foresight is 
that, when prices are rising, the rate of interest is usually 
high, but not so high as it should be to make a perfect 



362 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIX 

compensation for the rise; and that, on the other hand, 
when prices are falUng, the rate of interest is usually low, 
but not so low as it should be to make a perfect compensa- 
tion for the fall. Thus the rate of interest, though par- 
tially adjusted during transition periods, is not sufficiently 
adjusted to alter the essential fact emphasized in Chapter 
X ; namely, that during rising prices the burden of debts 
grows lighter on borrowers, and that, consequently, "enter- 
priser borrowers " tend to be prosperous ; while, reversely, 
when prices are falling, the same people lose, and "business 
is dull." 

§ 4. Effect of Unequal Foresight 

Besides being inadequate, foresight is unequally dis- 
tributed. Different persons differ greatly in their power 
to foresee ; and, in general, borrowers foresee better than 
lenders. The great borrowers of to-day are not, as is often 
supposed, the ignorant poor, but the alert and well-informed 
rich. It is the function of these people to look ahead, and 
the consequence is that they foresee a rise or fall of prices 
more quickly than the lenders or bondholders, who are only 
silent partners in business. Now, a consequence of the 
superiority in foresight of borrowers over lenders is that 
the borrowers are willing, during rising prices, to pay a 
higher rate than they have to pay, whereas the lenders do 
not see any reason for raising the rate of interest. Sup- 
pose that the rate of interest, on a basis of stationary 
prices, is five per cent, and that prices are rising two per 
cent per annum. We know that the rate of interest ought 
to be seven per cent in order to make things even; but 
let us suppose that the borrowers foresee that prices are 
going to rise two per cent per annum, and that they are per- 
fectly willing to pay seven per cent, where otherwise they 
would pay five per cent. Let us suppose, also, that the 
lenders are not alert enough to see why interest should be 



Sec. 4] INTEREST AND MONEY 363 

any more than five per cent. The consequence will be that 
the rate of interest will not rise as high as seven per cent, but 
will be something like six per cent. The consequence of this, 
in turn, is that the borrowers, who are willing to pay seven 
per cent to get the same loans that they used to get at five 
per cent, when they find that they do not have to pay seven 
per cent, but can get loans at six per cent, will increase 
the size of their loans. Thus borrowers are encouraged 
to borrow more. Likewise lenders are encouraged to lend 
more, for they find that they can get six per cent when they 
are willing to take five per cent. This six per cent is low 
in the eyes of the borrowers, but high in the eyes of the 
deluded lenders. The consequence, therefore, is an infla- 
tion of loans stimulated from both sides of the market. 

In a previous chapter we saw that an increase of loans of 
banks produces an increase of deposits, inflates the currency, 
and makes prices rise further, and so on around the circle of 
inflation, loans, deposits, and inflation again. The circular 
process has to come to a stop sometime, but it never does 
come to a stop until the rate of interest is adjusted. As long 
as the rate of interest still stays too low, borrowing will 
continue too high. When presently people wake up to the 
danger of this condition of inflated loans and deposits, the 
rate of interest does go up, discouraging loans and precipitat- 
ing a crisis. Then we have the back-flow : prices decreas- 
ing, interest falling, and discouragement of business. This 
has all been explained in a previous chapter. What needs 
emphasis here is that an essential factor in all these 
changes is the rate of interest. The rate of interest is 
the key to the situation. Were the rate of interest properly 
adjusted, there would be less trouble, if, indeed, there were 
any at all. Crises would be fewer, and they would be less 
severe. 

How, then, can we get a better adjustment of the rate of 
interest? One way is to prevent these changes in price 
levels as much as possible. This we have already discussed. 



364 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XIX 

Another is to have men more alive to the future and more 
quick to predict what is going to happen to prices. Edu- 
cation on this line will go on and is going on through the 
trade journals. Still another way is through the removal 
of the existing prejudice against raising the rate of interest. 
We still inherit the old idea that interest is ■* usury " or 
robbery. If we could once get rid of the prejudice against 
allowing the rate of interest to rise high as well as to fall 
low, that is, could regard the rate of interest as properly 
subject to fluctuation and as being a market price changing 
day by day, like any other price, a long step would be taken 
toward preventing crises. 



CHAPTER XX 

IMPATIENCE FOR INCOME THE BASIS OF INTEREST 

§ I. The Productivity Theory 

In the preceding chapter we have considered the relation 
of money to the rate of interest. We saw that the money 
supply has no effect on the rate of interest, except during 
transition periods. The real riddle of interest, therefore, still 
remains unsolved. Why is there such a thing as a rate of 
interest, even when the purchasing power of money is con- 
stant, and what, then, determines that rate ? What other 
factors besides changes in the purchasing power of money 
affect the rate of interest ? We must now go back of money 
and study the supply and demand of loans. 

In our study of prices we began by considering first the 
part played by money, and then undertook an analysis of 
supply and demand of goods. We are following the same 
order in our study of that pecuHar price called the rate of 
interest. We have thus far considered only the part played 
by money, and now are ready to undertake an analysis of 
the supply and demand of loans. We shall find that, con- 
trasted with the supply and demand of goods, which resolves 
itself in the last analysis into a comparison between dif- 
ferent marginal desirabilities and undesirabiUties, which are 
simultaneous, the supply and demand of loans resolves itself 
in the last analysis into a comparison between different mar- 
ginal desirabilities and undesirabiUties, which are not simul- 
taneous, but are distributed at different points in time. 

365 



366 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XX 

Before, however, we can fully justify these propositions, 
we shall need to clear the way by removing some of the many 
fallacies and pitfalls which surround the subject. 

There is, perhaps, no other "nut" so hard to "crack "in 
all economics as this one of the rate of interest ; and before 
most persons have grown old enough to consider the subject 
philosophically, they have absorbed, more or less uncon- 
sciously, a number of untenable and even conflicting theories. 

Next to the money fallacies which were considered in the 
last chapter, one of the most persistent fallacies is that 
the rate of interest represents the " rate of productivity of 
capital." If a man who has never thought on the subject 
is asked why the rate of interest is five per cent, he will 
almost invariably answer, " because capital produces five 
per cent." A $100,000 mill will produce a net income of 
$5000 a year; a $100,000 piece of land vnll produce a 
net crop worth $5000 a year ; and so on. When the 
rate of interest is five per cent, nothing at first sight seems 
more obvious than that it is five per cent because capital 
yields five per cent. Since capital is productive, it seems 
self-evident that an investment of $100,000 in productive 
land, machinery, or any other form of capital will yield a rate 
of interest proportionate to its productivity. This proposi- 
tion looks attractive, but it is superficial. Why is the land 
worth $100,000 ? Simply because $100,000 is the discounted 
value of the expected $5000 a year. We have seen in pre- 
vious chapters that the value of capital is derived from the 
value of its income, not the value of the income from that of 
the capital. Capital value is merely the present or dis- 
counted value of income. But whenever we discount 
income, we have to assume a rate of interest. If we have 
wealth yielding a given perpetual income of $5000 a year 
and capitalize this income at five per cent, we get $100,000 as 
the value of the wealth. It would be reasoning in a circle 
to derive the rate of interest (five per cent) by dividing 
the $5000 by the $100,000 ; for this $100,000 was itself 



Sec. i] the BASIS OF INTEREST 367 

derived by assuming the rate to be five per cent in the 
first place. Again, if we have wealth yielding $ 1000 for 
50 years, and capitalize it at five per cent, we find its 
present value to be $18,300. One year later, by the same 
process, its value wiU be $18,215, showing a depreciation 
of $85. If we subtract this depreciation from the $1000 
of income, we obtain $915 as the interest accrued, which 
is exactly five per cent of the $18,300, but this result, five 
per cent, is a necessary consequence of the assumption 
of five per cent when we calculated the present value as 
$18,300 and $18,215. Had we assumed four per cent for 
this calculation, we would have gotten four per cent of 
accrued interest as a result. We always find at the end 
exactly what we assumed at the beginning ; but if we are 
not careful, we delude ourselves into thinking that we are 
finding something new. 

It is evident that if an orchard of ten acres yields 100 
barrels of apples a year, the physical-productivity, 10 
barrels per acre, does not of itself give any clew to what 
rate of return on its value the orchard yields. Even as- 
suming a given value for the 100 barrels of apples as, say, 
$200, we are still unable to state what the rate of interest 
is. We can only say that the orchard yields $2 per acre. 
We cannot say it yields so much per cent. What then is 
the rate of interest yielded by the orchard ? This ques- 
tion cannot be answered without a knowledge of the value 
of the orchard ; and the value of the orchard cannot be 
obtained without assuming a rate of interest and using it 
in discounting the income which the orchard yields. The 
orchard produces the apples, but the value of the orchard 
does not produce the value of the apples ; on the contrary, 
the value of the apples produces the value of the orchard. 

The following diagram shows the typical relation between 
capital and the productivity of capital in the physical sense 
and also in the value sense — which latter sense is the 
important factor in studying the rate of interest. 



368 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XX 

Present Capital Future Income 

Instruments ^ Benefits 

Value of instruments •< Value of benefits 

This scheme signifies (i) Any physical instrument, such, 
for instance, as land, railways, factories, dwellings, or food, is 
the means for obtaining benefits in the future ; this first 
step in the sequence pertains to the study of the " tech- 
nique " of production, and involves no rate of interest. 
(2) The benefits are valued in money; this step pertains 
to the study of prices. (3) From the value of the benefits 
thus obtained is computed the value of the original instru- 
ment by the process of discounting; it is clearly with this 
last process that we are concerned in the study of 
interest. 

The paradox that, when we come to the value oi capital, it is 
value of income which produces the value of capital, and not 
the reverse, is, then, the stumbling-block of the productivity 
theorists. It is clear, of course, in any particular investment, 
that the selling value of the stock or bond is dependent on 
its expected income. And yet business men, although con- 
stantly employing this discount process in specific cases, usu- 
ally cherish the illusion that they do so because their capital- 
value, if invested in some vague "other use," would actually 
produce interest. They fail to observe that the principle of 
discounting the future is universal, and applies to any invest- 
ment whatsoever, and that in such a discount-process there 
is necessarily assumed the very rate of interest we are seek- 
ing to explain. It is futile to derive the rate of interest from 
the productivity of capital. 

The futility of this productivity theory may be further 
illustrated by observing the effect of a change of productivity. 
If productivity makes interest, then a change in produc- 
tivity ought to make a corresponding change in the rate 
of interest. Yet, if an orchard could in some way be 
made to yield double its original crop, though its yield in 



Sec. 2] THE BASIS OF INTEREST 369 

the physical sense would be doubled, in the sense of the 
rate of interest its yield would not be necessarily 
affected at all — certainly not doubled. For the orchard 
whose yield of apples should increase from $1000 worth to 
$2000 worth would itself correspondingly increase in value. 
For some reason or other, people would find themselves call- 
ing it a $40,000 orchard instead of a $20,000 orchard ; and 
the ratio of the income to the capital- value would then remain 
just what it was before, namely, five per cent. Of course 
it is true that if an orchard which had already been bought 
for $20,000 on the assumption that it would yield only $1000 
worth of crops per year should in some way be doubled 
in productivity, the owner would be making ten per cent 
on his original investment, for his original investment was 
made before either he or the man who sold it to him knew 
that the orchard would increase in productivity. Had the 
purchaser known this fact in advance, he would have 
been quite willing to pay more than the $20,000 which we 
have supposed him to pay ; and as soon as this new knowl- 
edge is acquired, he will revalue the orchard according to 
his new expectations. Realizations do not always or even 
usually correspond to expectations. Properly speaking, the 
rate of interest applies only to expectations. To raise the 
productivity of the orchard or of any other article of 
wealth will raise its value also. The idea of raising the 
rate of interest by increasing the productivity of capital is, 
therefore, like the idea of raising one's self by one's boot 
straps. 

§ 2. The Socialist Theory 

So much for the productivity theory. We have next the 
socialist theory. The socialist has the idea that interest 
is robbery. He says " it is all wrong that the capitalist who 
does not lift a finger should get any pay; he is getting 
something for nothing, and that is interest; interest is 



370 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XX 

robbery; interest is sucking the blood out of somebody 
else, viz., the workman." According to the socialist theory, 
especially as represented by Karl Marx, interest is exploi- 
tation. The socialists say that labor produces capital, and 
therefore produces the interest from capital, and therefore 
labor should get all the income from capital ; and since 
the laborer does not get it all, it must be true that it 
is held back by somebody who is in a position of van- 
tage to steal it. This is the key of so-called " scientific 
socialism." There are many motives for socialism, but so 
far as it has an economic theory behind it, this is that theory. 
According to it, the capitalist holds a club over the 
workman and virtually says : "If you will come to-day and 
work for me, I will give you half of what you produce ; I 
have got the capital, and you can't get on without me, and 
therefore I am in a position to rob you. Take what you 
can get, or get nothing." 

The socialist theory involves two propositions : first, that 
all income and all capital are practically produced by labor ; 
and, secondly, that all the resulting income should be paid 
to the laborer. Now the first proposition is much more 
nearly correct than the second. We need not contest it in 
order to see the fundamental error in the theory of socialism. 
Let it be granted that practically every instrument of pro- 
duction is produced by labor; let it be granted that the 
capitaHst is always living on the product of past labor; 
that a millionaire who gets his income from railroads, ships, 
and houses, all products of labor, is reaping what labor 
sowed ; that the capitalists of to-day are receiving compound 
interest on the labor of bygone times. 

It does not follow, however, that injustice has been done 
to the laborer. Let us consider the case of a tree which is 
planted with one dollar's worth of labor, and twenty-five 
years later is worth three dollars. The socialist virtually 
asks, " Why should not the laborer who planted the tree 
receive three dollars instead of one dollar for his work ? " 



Sec. 3] THE BASIS OF INTEREST 37 1 

The answer is chat he may receive it, provided he will wait 
twenty-five years for it ! As Bohm-Bawerk, an authority 
on interest, says : " The perfectly just proposition that the 
laborer should receive the entire value of his product may 
be understood to mean either that the laborer should now 
receive the entire present value of his product, or should 
receive the entire future value of his product in the future. 
But Rodbertus and the sociahsts expound it as if it meant 
that the laborer should now receive the entire future value 
of his product." 

It would be a mistake to say that there is no exploitation 
of laboring men by capitalists, because we know the contrary 
to be a fact, but it would likewise be a mistake to condemn 
all interest on the ground of exploitation. The basis of 
interest is much deeper. It lies in the preference for 
present over future goods. Neither the employer nor the 
employee likes to wait a long time for the fruits of any 
enterprise in which he engages. But somebody must 
wait, and whoever does so is clearly entitled to some 
reward. 

§ 3. Impatience the Source of Interest 

The essence of interest is impatience, the desire to obtain 
gratifications earlier than we can get them, the preference for 
present over future goods. It is a fundamental attribute of 
human nature ; and as long as it exists, so long will there 
be a rate of interest. 

Interest is, as it were, human impatience crystallized into a 
market rate. The market rate of interest is formed out of the 
various degrees or rates of impatience in the minds of different 
people. The rate of impatience in any individual's mind is 
his preference for an additional dollar, or one dollar's worth of 
goods, available to-day, over an additional dollar, or dollar's 
worth of goods, available a year from to-day. In other 
words, it is the excess of the marginal desirability of 



372 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XX 

to-day's goods over the marginal desirability of next year's 
goods viewed from to-day's standpoint. It can be expressed 
in numbers as the premium that a man is wilHng to pay for 
this year's over next year's goods. If, for instance, in order 
to get $1 to-day he is wiUing to promise to pay $1.05 next 
year, then his rate or degree of impatience is said to be five 
per cent. The present $1 is worth to him so much that in 
order to get it he is wilHng to pay for it five per cent more 
than |i in the future; it is the willingness to do this to 
gratify one's impatience which causes the phenomenon of a 
rate of interest. A man will prefer to have a machine to-day 
rather than a machine in the future ; a house to-day rather 
than a house a year from now ; a piece of land to-day rather 
than a piece of land when he is ten years older ; he would 
rather have some food to-day than wait until next year for 
it, or for a suit of clothes, or stocks or bonds, or anything 
else. 

But what are these present and future "goods" which are 
thus contrasted? At first sight it might seem that the 
"goods" compared may be indiscriminately wealth, prop- 
erty, or benefits. But when present capital (whether 
capital-wealth or capital-property) is preferred to future 
capital, this preference is really a preference for the income 
of the first capital as compared with the income of the second. 
The reason why we would choose a present fruit tree rather 
than a similar fruit tree available in ten years is that the 
fruit of the first will be available earlier than that of the 
second. The reason we prefer immedia:te tenancy of a house 
to the right to occupy it in six months is that the uses of the 
house will begin six months earlier in the one case than in the 
other. In short, capital-wealth available early is preferred 
to capital-wealth of like kind available at a more remote 
time, simply because the income of the former is available 
earher than the income of the latter. For the same reason 
early capital-property is preferred to late capital-property 
of a similar kind ; for property is merely a claim to future 



Sec. 3] THE BASIS OF INTEREST 



373 



income ; and the earlier the property is acquired, the earlier 
will the income accrue, the right to which constitutes the 
property in question. 

Thus, impatience for goods of any kind resolves itself into 
impatience for income, — i.e., preference for immediate in- 
come over remote income. Moreover, the preference for 
immediate income over remote income resolves itself into the 
preference for present enjoyable income over future enjoyable 
income. The income from an article of capital which consists 
merely of an "interaction" is desired for the sake of the final 
income to which that interaction paves the way. We prefer 
present bread-baking to future bread-baking because the 
enjoyment of the resulting bread is available eariier in the 
one case than in the other. Present weaving is preferred 
to future weaving, because the earUer the weaving takes 
place, the sooner will the cloth be manufactured, and the 
sooner will the clothing made from it be worn by the con- 
sumer. 

When, as is usually the case, exchange intervenes between 
the weaving and the use of the clothes, the goal in the process 
is somewhat obscured by the fact that the manufacturer 
regards his preference for present weaving over future weav- 
ing as due not to the fact that the clothes will be more 
early available to those who will wear them, but to the fact 
that he will be enabled to obtain a quicker income by selling 
the cloth earlier. To him early sales are more advantageous 
than deferred sales, because the earlier the money is received, 
the earlier can he spend it for his own personal uses, — the 
shelter and the comforts of various kinds constituting his 
real income. It is not he, but his customers, whose prefer- 
ence for present cloth over future cloth is based on the earlier 
availability of the clothes which can be made from it. But in 
both cases the mind's eye is fixed on some ultimate enjoy- 
able income, i.e., benefits, to which the interaction in ques- 
tion is a mere preparatory step. 
The same principles apply where corporations or firms 



374 ELEMENTARY PRINCIPLES OF ECONOMICS [Ckap. XX 

borrow and lend. Here the relation of enjoyable income 
is more indirect, and yet it is still the guiding force. For 
borrowing and lending, when directed by the directors of a 
company on behalf of the stockholders or bondholders, have 
reference to the enjoyable income, not of the directors, but of 
the stockholders and bondholders. 

We thus see that all preference for present over future 
goods resolves itself, in the last analysis, into a preference 
for early enjoyable income over late enjoyable income. Every 
preference for present over future goods reduces itself, 
therefore, to this preference for present over future satis- 
factions. 

The preference for present over future goods, when thus 
reduced to its lowest terms, rids the values of the contrasted 
present and future goods of the interest element, which, 
in all other attempts at explanation, is so unconsciously 
presupposed. When any other goods than enjoyable in- 
come are considered, their values already imply a rate of 
interest. When, for instance, we say that interest is the 
premium on the value of a present house over that of a future 
house, we still leave the problem of interest unsolved ; for 
we forget that the value of each house — the future one not 
less than the present one — is itself based on a rate of in- 
terest. As we have seen, the price of a house is the dis- 
counted value of its future income, and in the process of 
discounting there always lurks a rate of interest. When 
we compare the values of present and future houses, there- 
fore, both terms of the comparison involve the rate of 
interest. But when present enjoyable income is compared 
with future enjoyable income, the case is different, for the 
value of enjoyable income involves no interest whatever. 

We have thus reduced the problem of determining the 
rate of interest to the problem of determining the premium 
which people are willing to pay for present enjoyable in- 
come in terms of future enjoyable income. 



CHAPTER XXI 

INFLUENCES ON IMPATIENCE FOR INCOME 

§ I. Differences in Impatience Due to Differences in 
Human Nature 

But we have not yet wholly solved the problem of interest. 
It is not enough to know that the more impatient a people 
are, the higher will be their rate of interest, and the more 
patient they are, the lower will be their rate of interest. 
We must also know on what causes the degree or rate of 
impatience depends. It depends principally upon the 
character of the individual and the character of the income 
which he possesses. It is clear that the degree of impa- 
tience which corresponds to a specific income-stream will not 
be the same for everybody. One man may have a degree 
or rate of impatience of five per cent and another a rate of 
impatience of ten per cent, although both have the same 
income. The difference will be due to a difference in the 
personal characteristics of the individuals. These charac- 
teristics are chiefly five in number : (i) foresight, (2) self- 
control, (3) habit, (4) expectation of hfe, (5) love for pos- 
terity. We shall take these up in order. 

(i) First, as to foresight. Generally speaking, the greater 
the foresight, the less the impatience, and vice versa. 
In the case of primitive races and uninstructed classes 
of society, the future is seldom considered in its true pro- 
portions. The story is told of a shiftless householder who 
would not mend his leaky roof when it was raining, for fear of 

375 



376 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 

getting more wet, nor when it was not raining, because he 
did not then need shelter. Among such persons im^patience 
for present gratification is powerful because their compre- 
hension of the future is weak. If we compare the Scotch 
and the Irish, we shall find a contrast in this respect. 
The Irish, in general, lack foresight and are improvident, 
and the Scotch have foresight and are provident. Conse- 
quently the rate of interest is high in Ireland and low in 
Scotland. 

These differences in degrees of foresight produce corre- 
sponding differences in the dependence of impatience on 
the character of income. Thus, for a given income, say 
$1000 a year, the reckless might have a rate of impatience 
of ten per cent, when the forehanded would experience a 
rate of only five per cent. Therefore, impatience, in 
general, will be greater in a community consisting of 
reckless individuals than in one consisting of the opposite 
type. 

(2) We come next to self-control. This trait, though 
distinct from foresight, is usually associated with it and has 
very similar effects. Foresight has to do with thinking, self- 
control with willing. A weak will usually goes with a weak 
intellect, though not necessarily, and not always. The 
effect of a weak will is similar to the effect of inferior fore- 
sight. Like those workingmen who cannot carry their pay 
home Saturday night, but spend it in a grogshop on the 
way, many persons cannot deny themselves any present 
indulgence, even when they know definitely what the con- 
sequences will be in the future. Others, on the contrary, 
have no difficulty in controlling themselves in the face of 
all temptations. 

(3) The third characteristic of human nature which needs 
to be considered is habit. That to which one is accus- 
tomed exerts necessarily a powerful influence upon his 
valuations and therefore upon his impatience. This 
influence may be in either direction. A rich man's 



Sec. i] influences ON IMPATIENCE FOR INCOME 377 

son who has been brought up with expensive habits, 
when he finds himself with a smaller income than his 
father provided him during his formative years, will be 
more impatient for income than a man who has this 
same income but who has climbed up instead of climbed 
down. 

(4) The expectation of life will affect a man's degree of 
impatience. A man who looks forward to a long life will have 
a relatively high appreciation of the future, which means 
a relatively low appreciation of the present, i.e., a low degree 
of impatience ; whereas a man who has a short life to look 
forward to will want it at least to be a merry one. " Eat, 
drink, and be merry, for to-morrow we die " is the motto 
applying to this type. 

(5) The fifth circumstance is love for posterity. Prob- 
ably the most powerful cause tending to reduce the rate of 
interest is love for one's children and the desire to provide 
for their good. When these sentiments decay, as they did 
decay at the time of the decline and fall of the Roman 
Empire, and it becomes the fashion to exhaust wealth in 
self-indulgence and leave little or nothing to offspring, the 
rate of impatience and the rate of interest will be high. 
At such times the motto, " After us the deluge," indicates 
the feverish desire to squander in the present, at whatever 
cost to the future. A noted gambler, who had led a wild 
and selfish life, once said, when life insurance was first 
explained to him, " I have seen many schemes for making 
money, but this is the first time I have seen a scheme where 
you had to die before you could rake in the pile." That 
man did not care for a payment which would come in after 
his death. But there are many men who do, and in fact 
care much more for it than for anything else in the world. 
This care leads them to insure their lives in order that they 
may leave the money to their families. Their desire to 
provide for those who survive them tends to make them 
more patient, i.e., tends to reduce their impatience to enjoy 



378 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 

income immediately. Life insurance, by training people to 
provide for posterity, is acting as one of the most powerful 
means of lowering the rate of impatience and therefore the 
rate of interest. At present in the United States the insurance 
on lives amounts to $20,000,000,000. This represents, for 
the most part, future income to be received by the next 
generation by reason of sacrifices of income made by the 
present generation. These sacrifices spring from a low 
rate of impatience, and tend to produce a low rate of 
interest. 

Thus we see that men may differ in many ways which 
affect the rate of interest and the rate of impatience. 
We may contrast two extreme types of men. Men who 
are shortsighted, or weak willed, or have the habits of a 
spendthrift, or look forward to a short or uncertain life, 
or are selfish and have no regard for posterity, will (other 
things equal) have a high degree of impatience. Men 
who possess foresight, self-control, habits of thrift, con- 
fidence in length of life, and altruism with respect to 
posterity, will (other things equal) have a low degree of 
impatience. 

§ 2. Differences in Impatience Due to Differences in 

Income 

But not only does impatience vary as between different 
individuals ; it varies also for the same individual according 
to circumstances. The most important circumstance affect- 
ing a person's degree of impatience is the character of his 
expected income in the immediate and in the remote future. 
One's impatience for satisfactions will vary inversely as 
the abundance of his immediate as compared with his remote 
satisfactions. If the future satisfactions which he expects 
and looks forward to are very great, and his present satis- 
factions are very small, he will be impatient to hurry from 
his present scarcity and arrive at the expected future abun- 



Sec. 3] INFLUENCES ON IMPATIENCE EOR INCOME 



379 



dance; that is, he will have a high rate of preference 
for present over future satisfactions. This is on the same 
principle that prices are high when goods are scarce. The 
preference for present satisfactions is high if present satis- 
factions are scarce. Now one's impatience to bring future 
satisfactions nearer the present will depend on one's whole 
future stream of satisfactions, i.e., what we call his final 
enjoyable income. It will depend on three chief charac- 
teristics of that income : first, as just said, it will depend on 
its distributio?i in time, i.e., the relative abundance of his 
immediate as compared with his remote satisfactions ; 
secondly, on the amount of the income, i.e., whether his satis- 
factions are, as a whole, scant or abundant ; thirdly, on the 
uncertainties of the income, i.e., to what extent his satisfac- 
tions throughout future years are subject to chance, that is, 
may turn out to be greater or less than he first expected. 



§3. 



Influence of the Distribution in Time of the Income- 
stream ^.-'-— """''• i„. 



\ 






We have first to, 
consider the • in- 
fluence which the 
distribution in 
time of income 
has upon the im- 
patience for in- 
come. Three dif- 
ferent types of 
distribution in 
time may be 
distinguished : 
uniform income. 



2600 

r.406 

2200 

2000 

I800 

I600 

1400 

1200 

1000 

800 

600 

400 

aoo 



1 9IO '1 1 '12 



'15 '16 '\7 



r3 14 

FlG. 41. 

consisting of equal yearly items, as represented by 
the dark lines in Figure 41 (in which, as in 
previous diagrams, the heights of the successive vertical 



380 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 



3000 

2600 

2600 

2400 

2200 

2000 

I800 

I SCO 

1 400 

.1200 

1000 

800 

600 

4O0 

200 



1 910 '11 '12 



'13 '14 

Fig. 42. 



3000 

28QO 

2©00 

2400 

2200 

2OO0 

1 300 

leOQ 

1400 

1200 

1000 

800 

6O0 

400 

ZOO 



'15 'I& '17 



lines represent the amounts of the successive installments 

of income, say $1900 a year) ; increasing income, as 

represented in 
Figure 42 (in 
which the income 
is supposed to 
increase from 
$1200 a year in 
191 1 to nearly 
$3000 in 1917) ; 
and decreasing 
income, as repre- 
sented in Figure 
43 (in which the 
income is sup- 
posed to decrease 
fromalmostl30oo 
in 191 1 to about 
$1200 in 191 7). 

The effect of possessing an increasing income (Fig. 42) is, as 

we have already 

indicated, tomake 

the possessor im- 
patient to get 

the larger income 

which the future 

holds or keeps 

back. A man who 

is now enjoying 

an income of only 

$1000 a year, but 

expects in ten 

years to be 

enjoying one of 

$10,000^ a year, ^^^^ .,, ,,3 .,3 ',4 

will be impatient Fig. 43. 

















































































































































































































































































































































































































































































































J 









ns 



'16 '17 



Sec. 4] INFLUENCES ON IMPATIENCE POR INCOME 381 

to have those ten years elapse. He has " great expecta- 
tions." He may, to satisfy his impatience, borrow money 
to eke out this year's income, and make repayment by 
sacrificing from his more abundant income ten years later. 

Reversely, a gradually decreasing income (Fig. 43) , mak- 
ing, as it does, the earlier income relatively abundant, and 
the remoter income relatively scarce, tends to reduce impa- 
tience, or the preference for present as compared with future 
income. The man with a descending income already has 
a high income without being compelled to wait for it. With 
him there is little reason for impatience — there is nothing 
to be impatient for ; on the contrary, the future does not 
look at all inviting. The outlook, so far from tending to 
make him borrow, tends to make him wish to save from 
his present abundance to provide for his coming need. 

The extent of these effects will, as we have already seen, 
vary greatly with different individuals. Corresponding to 
a given ascending income, one individual may have a rate 
of impatience of ten per cent and another of only four per 
cent. What we need here to emphasize is merely that, 
in the case of both of these individuals, a descending in- 
come causes a lower degree of impatience than an ascend- 
ing income. 

§ 4. Influence of the Size of the Income-stream 

We have considered the dependence of impatience for 
expected income on the distribution of that income 
in time. Our next topic is the dependence of impa- 
tience on the size of income. In general, it may 
be said that the smaller the income a man has, the higher is 
his preference for present over future income. It is true 
that a small income implies a keen appreciation of future 
wants as well as of immediate wants. Poverty bears down 
heavily on all parts of a man's Hfe, both that which is 
immediate and that which is remote. But it enhances the 



382 ELEMENTARY PRINCIPLES OF ECONOMICS Chap. XXI 

desirability of immediate income even more than of future 
income. 

This result is partly rational, because of the importance 
of supplying present needs in order to keep up the con- 
tinuity of life and the ability to cope with the future ; and 
partly irrational, because the pressure of present needs 
blinds one to the needs of the future. 

As to the rational side, it is clear that present income is 
absolutely indispensable, not only for the present, but even 
as a precondition to the attainment of future income. One 
break in the thread of life is sufficient to destroy all future 
enjoyment. It is of the utmost importance, therefore, to 
keep up life. As the phrase is, "a man must live," and in 
the present a man must keep his hold on life in order to have 
any life in the future. If, then, a man were on a desert 
island and had only such rations as would last a few months, 
he would naturally prefer to use them immediately — 
sparingly, but immediately ^ — rather than to put off their con- 
sumption ten years ; because if he put off consuming them 
he could not consume them at all ; he would die in the mean- 
time. And in general, a man who is poor, and upon whom 
poverty presses so as to make it hard to make both ends 
meet, will always have a higher realization and apprecia- 
tion of the present than a man who is rich. 

As to the irrational side, the poorer a man, the more his 
eyes are blinded to future needs. He is too much occupied 
with the need of the present, and shuts his eyes to the 
future. To him " sufficient unto the day is the evil thereof." 
We all suffer from lack of perspective, and tend to exaggerate 
the needs of the present. Poverty especially tends to distort 
the perspective. Its effect is to relax foresight and self- 
control, and tempt one to " trust to luck " for the future, 
if only the all-absorbing clamor of present necessities may 
thus be satisfied. 

We see, then, that a small income tends to produce a 
high degree of impatience, partly from lack of foresight 



Sec. 5] INFLUENCES ON IMPATIENCE FOR INCOME 383 

and self-control, and partly from the thought that pro- 
vision for the present is necessary both for itself and for 
the future as well. 

§ 5. Influence of Uncertainties of Income 

The next influence on impatience and therefore on the 
rate of interest consists in the risks or uncertainties attach- 
ing to prospective incomes. Now uncertainties affect im- 
patience in several different ways. In general, risks tend 
to raise the degree of impatience. There are four ways 
in which risk tends to increase impatience, and one in which 
it tends to decrease impatience. 

First, we know that if a loan is risky, the rate of interest 
has to be high. If the repayment of a loan is regarded as 
uncertain, this uncertainty to the lender will have to be 
offset by an increase in the rate of interest, and produces 
a correspondingly high rate of impatience in the case of 
risky loans. The rate of interest on risky loans thus in- 
cludes, as it were, an element of insurance against loss. 
Strictly speaking, such a rate is not pure interest ; for we 
have defined a rate of interest as the premium paid for 
present money in future money, on the assumption that 
both sums are certain. 

But even the pure rate of interest — the rate in riskless 
loans — will be raised by risk in certain ways. One way in 
which risk tends to raise the rate of impatience has already 
been mentioned in § i, namely, when the risk is of life, 
— that is, of its terminating before the lender finds himself 
able to enjoy the fruits of his loan. This acts like the 
risk in the loan itself. You may tell a man he is perfectly 
sure of being repaid his loan fifty years from now. But 
will he live so long ? It is cold comfort to tell him he is 
sure to get his money after he is dead ! A sailor is a type 
of man who is constantly taking this fact into account. He 
knows that almost any day he may be shipwrecked, and the 



384 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 

consequence is that he prefers money ready to spend to-day 
to money available only next year. Sailors are proverbial 
spendthrifts and have a proverbially high degree of impa- 
tience. 

The third case is where the receipt of the income itself 
is uncertain, its uncertainty applying alike to all times. 
Such a condition largely explains why salaries and wages are 
lower than the average earnings of those who work for them- 
selves. Those who choose salaries rather than profits are 
willing to accept a small but sure income in order to get 
rid of a precarious though possibly larger one. Since a 
risky income, if the risk apphes evenly to all parts of the 
income-stream, is nearly equivalent to a low income, and 
since a low income, as we have seen, tends to intensify im- 
patience, risk, if uniformly distributed in time, must tend 
to increase impatience. 

The fourth way in which risk tends to increase impatience 
is seen where immediate income is risky as compared with 
remote income. A man in time of war, when there is pros- 
pect of peace in the future, looking forward to a relatively 
safe income in the future, will have a high degree of im- 
patience for that future to arrive, because the present risky 
income is in his eyes not equivalent to the future safe income. 

These, then, are four ways in which risk tends to 
increase impatience. There is, however, one way in which 
risk tends to decrease impatience. The instance just given 
is one in which income in the immediate future is risky, but 
income thereafter safe. That sometimes happens, as just 
indicated, where in time of war man expects peace in the 
future, or in time of sickness he expects to get well and re- 
sume his regular earning power. Nevertheless, there are 
numerous examples of the opposite type, where the risk 
applies to the future and not to the present. If a ship owner, 
for instance, has his ship in port to-day, but is going to sail 
within a few months, his risks are high in the future as com- 
pared with the present. His future looks dubious, and 



Sec. s] INPLUENCES ON IMPATIENCE FOR INCOME 385 

that will cause him to be less impatient, because a risky 
future income is Hke a small future income, and we 
have seen that a small future income tends to les- 
sen impatience. An income which gets more and more 
risky in the future is therefore like an income which gets 
smaller and smaller in the future. In actual fact, such a 
type is not uncommon. The remote future is usually less 
known than the immediate future. This means that the 
risk connected with distant income is greater than that con- 
nected with income near at hand. The chance of disease, 
accident, disability, or death is always to be reckoned with, 
but under ordinary circumstances is greater in the remote 
future than in the immediate future. Consequently there 
is usually a tendency, so far as this influence goes, toward 
a low degree of impatience. This tendency is expressed in 
the phrase to " lay up for a rainy day." 

Risk, then, operates in diverse ways according to diverse 
circumstances. We see that risk tends in some cases to in- 
crease and in others to decrease the degree of impatience. 
There is a common principle, however, in all these cases. 
Whether the result is a high or a low degree of impatience, 
the primary fact is that the risk of losing the income in a 
particular period of time operates as a virtual impoverish- 
m^ent of the income in that period, and hence increases the 
estimation in which it is held. If that period is a remote 
one, the risk to which it is subject makes for a high appre- 
ciation of remote income and a low degree of impatience ; if 
the period is the immediate future, the risk makes for a 
high appreciation of immediate income and a high degree of 
impatience ; if the risk is in all periods of time, it acts as 
a virtual decrease of income all along the line and promotes 
a high degree of impatience. From a practical point of 
view, there is no factor affecting the rate of interest more 
important than the factor called risk. This is because 
interest always has to do with the future and the future is 
always uncertain. 

2C 



386 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 

§ 6. Summary 

The impatience of any individual depends, then, partly 
on the character of that individual's income, i.e., on three 
characteristics of income : — 

(i) its distribution in time, 

(2) its amount, 

(3) its uncertainties. 

This proposition — that the preference of any individual 
for immediate over remote income depends upon the nature 
of his prospective enjoyable income — corresponds to the 
proposition in the theory of prices, that the marginal desir- 
abihty of any article depends upon the quantity of that 
article ; both propositions are fundamental in their respec- 
tive spheres. 

We see, then, that a man's impatience depends (i) 
upon his nature, and (2) upon his income. In the following 
illustrative table we see contrasted the supposed extreme 
types of income and of human nature, and see how 
impatience will differ among the four extreme cases here 
represented. 



Description op Income 


Corresponding Rate of Impatience 

TO AN InDIVIDUAI, WHO IS 








Short-sighted, weak- 
willed, accustomed 
to spend, without 
heirs 


Far-sighted, self-con- 
trolled, accustomed to 
save, desirous to pro- 
vide for heirs 


Small 
Large 


Increasing 
Decreasing 


Precarious 
Assured 


20% 

5% 


5% 
1% 



If we compare the figures in the same vertical column, we 
see that the lower figure is the smaller, expressing the in- 
fluence of the character of income. If we compare the figures 
in the same horizontal line, we see that the right-hand figure 



Sec. 6] INFLUENCES ON IMPATIENCE FOR INCOME 387 

is the smaller, expressing the influence of human nature. 
But a man may have an income-stream of a kind which 
tends to inflame his impatience, and at the same time a 
nature of a kind which tends to allay his impatience. The 
result will then be a compromise rate of impatience, say 
five per cent. Or a man may have an income-stream which 
tends to keep his impatience low, and a nature which tends 
to keep it high. Thus live per cent is found twice in the 
table forming a diagonal. The other diagonal shows the cc.n- 
trast between the extreme where both the character of the 
income and the nature of the individual conspire to make a 
very high degree of impatience, and the opposite extreme 
where they conspire to make a very low degree of impatience. 
The same individual may, in the course of his life, change 
from one extreme of impatience for income to the other. 
Such a change may be due to a change in the person's 
nature (as when a spendthrift is reformed or a man, origi- 
nally prudent, becomes, through intemperance, reckless and 
thriftless), or to a change in his income, whether in respect 
to size, distribution in time, or uncertainty. Every one at 
some times in his life doubtless changes his degree of impa- 
tience for income. In the course of an ordinary lifetime the 
changes in a man's degree of impatience are probably of 
the following general character : As a child he will have a 
high degree of impatience because of his lack of foresight and 
self-control. When he reaches the age of young manhood 
he may still have a high degree of impatience, but for a dif- 
ferent reason, viz. because he then expects a large future 
income. He expects to get on in the world, and he will 
have a high degree of impatience because of the relative 
abundance of the imagined future as compared with the 
realized present. When he gets a little farther along, and 
has a family, the result will be a low degree of impatience, 
because then the needs of the future rather than the endow- 
ment of the future will appeal to him. He will not think 
that he is going to be so very rich in the future ; on the 



38S ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXI 

contrary, he will wonder how he is going to get along in the 
future because he will have so many mouths to feed. He 
looks forward to the future expenses of his wife and children 
with the idea of providing for them — an idea which makes 
for a high relative regard for the future and a low relative 
regard for the present. Then when he gets a Httle older, 
and his children are married and gone out into the world 
and are taking care of themselves, he again has a high 
degree of impatience for income, because he expects to 
die, and he thinks, "Why shouldn't I enjoy myself during 
the few years that remain instead of piling up for the 
remote future ? " 



CHAPTER XXII 

THE DETERMINATION OF THE RATE OF INTEREST 

§ I. Equalizing Marginal Rates of Impatience by 
Borrowing and Lending 

In the preceding chapter we saw that the rate of prefer- 
ence for present over future goods is, in the last analysis, 
a preference for immediate over remote income ; that this 
preference depends, for any given individual, upon the 
character of his income-stream, — its size, its distribution 
in time, and its uncertainties ; and that the nature of this 
dependence varies with different individuals. 

The question now arises : What relation do these differ- 
ent " rates of preference " of different individuals have to 
the rate of interest ? 

For the moment let us assume a perfect market, in 
which the element of risk is entirely lacking, both with 
respect to the certainty of the expected income-streams 
belonging to the different individuals, and with respect to 
the certainty of repayment for loans. In other words, we 
assume that all individuals are initially possessed of fore- 
known income-streams, and are free to exchange any parts 
of them, that is any present or immediate income for any 
future or remote income. Prior to such exchange, the 
income-stream is supposed to be fixed in size and distri- 
bution in time ; that is, the capital instruments which the 
individual possesses are each supposed to be capable of 
only a single definite series of benefits contributing to his 
income-stream. 

389 



390 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

Under these hypothetical conditions, the rates of impa- 
tience for different individuals would become perfectly- 
equalized. 

For if any particular individual has a rate of impatience 
above the market rate, he will sell some of his surplus 
future income to obtain {i.e., " borrow") an addition to his 
present meager income. This will have the effect of de- 
creasing the desirability of his present income and increas- 
ing the desirability of the remaining future income. The 
process will continue until the rate of impatience of this 
individual is equal to the rate of interest. In other 
words, a person whose impatience rate exceeds the cur- 
rent rate of interest will borrow up to the point at which 
the two rates will be equal. Reversely, a man who, with 
a given income-stream, has a rate of impatience below the 
market rate, will sell {i.e., " lend ") some of his abundant 
present income to eke out the future, the effect being to 
increase his rate of impatience until it also harmonizes 
with the rate of interest. 

To put the matter in figures, let us suppose the rate of 
interest is five per cent, whereas the rate of impatience of a 
particular individual is at first ten per cent. Then, by 
hypothesis, the individual is willing to sacrifice $i.io of next 
year's income in exchange for $i of this year's. But in the 
market he is able to obtain $i for this year by sacrificing only 
$1.05 of next year's income. This ratio is, to him, a cheap 
price. He therefore borrows, say, $100 for a year, agreeing 
to return $105 ; that is, he contracts a loan at five per cent 
when he would be wilHng to pay ten per cent. This 
loan, by increasing his present income and decreasing his 
future, tends to reduce his rate of impatience from ten 
per cent to, say, eight per cent. Under these circum- 
stances he will borrow another $100, being now willing to 
pay eight per cent, but actually paying only five per 
cent. This loan will still further reduce his rate of im- 
patience. He will continue to borrow until his rate of 



Sec. i] determination OF THE RATE OF INTEREST 39 1 

impatience has been finally brought down to five per cent. 
Then for the last or " marginal " $100, his rate of im- 
patience will agree with the market rate of interest. As 
in the general theory of prices, this marginal rate, five 
per cent, being once established, applies indifferently to all 
his valuations of present and future income. Every com- 
parative estimate of present and future which he actually 
makes must be "marginal," i.e., relative to smaU additions 
to or subtractions from his present and future income. 

In like manner, if another individual, entering the loan 
market from the other side, has at first a rate of impatience 
of two per cent, he will become a lender instead of a borrower. 
He will hewilling to accept $102 of next year's income for $100 
of this year's income, but in the market he is able, instead of 
the $102, to get $105. As he can lend at five per cent when 
he would gladly do so at two percent, he jumps at the 
chance to get five per cent and invests, not one $ioo 
only, but another and another. His present income, be- 
ing reduced by the process, is now more highly esteemed 
than before, and his future income, being increased, is less 
highly esteemed. The result will be a higher relative 
valuation of the present, i.e., a higher rate of impatience, 
which, under the influence of successive additions to the 
sums lent, will rise gradually to the level of the market 
rate of interest. 

In such an ideal loan market, therefore, where every in- 
dividual could freely borrow or lend, the rates of impatience 
for all the different individuals will become equal to each 
other and to the rate of interest. 

To illustrate these principles by diagrams, let us suppose 
a man has a given income-stream, as indicated in Figure 44. 
It is assumed that his income-stream is an ascending one, 
as between one year and the next; that is, that the in- 
come for the year 1910 is relatively small and that for 
191 1 is relatively large. It may be that in 1910 he is 
ill, and therefore does not earn his usual amount of 



392 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 



700 






























































500 

L 400 
'too BQrr 














^ 


05 Returned. 
































■ov 


\fec 


i-^ 


























aoo 

lOO 
O 





























































































1910 1911 

Fig. 44. 



!912 



1913 



money, but that the year after he expects to get an unusual 
income from some particular source. This man will then 

probably be im- 
patient to get 
the large income 
he anticipates. 
He does not wish 
to wait till next 
year if he can 
avoid waiting. 
His impatience is 
due to a scarcity 
of income this year and an abundance of income next year. 
He will wish to adjust his income or rectify the disparity by 
increasing this year's income at the expense of next year's in- 
come. He will borrow, but borrowing changes the distribu- 
tion in time of his income-stream. His original income in 
the first year is $300, indicated by the dark line for the 
year 19 10. Next year his income is $600, indicated by the 
dark line for that year. The effect of borrowing will be 
to elevate the first line by $100 and to depress the second 
by $105. These two adjustments will lessen both the 
scarcity of this year's income and the abundance of next 
year's income. This will therefore modify the distribution 
in time of his income and lessen the valuation he puts on 
a dollar this year as compared with next year. This re- 
duces the premium he puts on this year's dollar, i.e., his 
rate of impatience. By increasing his loan he can evidently 
reduce this premium to conform to the rate of interest. 
He can also make other loan contracts, or plan to make 
them later, by which he can increase or decrease any 
year's income at the expense of an opposite change in that 
of some other year or years. In this way he can alter the 
distribution in time of his income-stream at will, and he 
will always so alter it as to make his rate of impatience 
equal to the rate of interest. He began with a rate of 



Sec. i] DETEEMINATION OF THE RATE OP INTEREST 393 



impatience greater than the market rate of interest, but 
ended in harmony with that rate. 

Figure 45 represents the income-stream of a man sup- 
posed to have a rate of impatience at first less than the 
rate of interest. If we choose, we may suppose that he 
has just received a small legacy which makes this year's 
available income unusually large, say $600, while he expects 
next year to have an unusually small income. Looking for- 
ward to next year, he sees that it will be hard to get along 
comfortably, while this year he has more than he needs. 
He therefore invests some of his present abundance to the 
extent of $100 in order to eke out his future scarcity by $105. 
He will do so, however, only provided his rate of impatience 
is less than the market rate of interest, five per cent, and 
he will do so only 
up to the point 
which will reduce 
his rate of 
patience to 
level of this rate 
of interest. 

The two men 
started out with 
rates of im- 
patience different from the market rate of interest. The 
market rate was five per cent, while the first man had a rate 
of impatience above this, and the second a rate of impatience 
below this. But when they finished their loan operations or 
readjustments of the distribution in time of their income- 
streams, they brought their rates of impatience each into 
harmony with the rate of interest and therefore with each 
other. Therefore, as long as there is a market in which 
everybody can borrow or lend at will at five per cent, 
everybody will have at the margin a rate of impatience 
of five per cent. Nobody will have a rate of impatience 
above five per cent, because, if it is at first above it, he 



im- 
the 



700 

600 

00 i_« 
500 

400 
500 
20O 
HOO 

o 





' 






















































.nt-U 


































1 




























\^^ 


nio5 


F?e 


turned 






























































_J 





























•49IO 



4911 

Fig. 45- 



r912 1913 



394 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

will borrow enough to bring it down to the market rate ; 
and nobody will have a rate below it, because, if it is at 
first below it, he will lend enough to bring it up to the 
rate of interest. 

Even men of widely different natures as to foresight, 
self-control, etc., will have the same marginal rates of im- 
patience. If such different men start with precisely the 
same sorts of income, they will have different rates of im- 
patience. But in that case they will not continue to have 
the same sorts of income. They will severally modify 
their income-streams until equal degrees of impatience are 
effected. They will then have, instead of different degrees 
of impatience, different sorts of income-streams. 

§ 2. Equalizing Marginal Rates of Impatience by 
Spending and Investing 

It must not be imagined that the classes of borrowers and 
lenders correspond respectively with the classes of poor and 
rich. Personal and natural idiosyncrasies, early training, 
and acquired habits, accustomed style of living, the usages 
of the country, and other circumstances will, by influencing 
foresight, self-control, regard for posterity, etc., determine 
whether a man's degree of impatience is high or low, and 
whether he becomes a borrower or a lender. 

It should be noted that borrowing and lending are not 
the only ways in which one's income-stream may be modi- 
fied. The same result may be accomplished simply by buy- 
ing and selHng property; for, since property rights are 
merely rights to particular income-streams, their exchange 
substitutes one such stream for another of equal value but 
differing in distribution in time, or certainty. This method 
of modifying one's income-stream, which we shall call the 
method of sale, really includes the method of loan ; for 
a loan contract is at bottom a sale ; that is, it is the ex- 
change of the right to present or immediately ensuing in- 



Sec. 2] DETERMINATION OF THE RATE OF INTEREST 395 

come for the right to more remote or future income. A 
borrower is a seller of a note of which the lender is the buyer. 
A bondholder is regarded indifferently as a lender and as a 
buyer of the bond. 

The concept of a loan may therefore now be dispensed 
with by being merged in that of sale. At bottom every 
" loan " is a sale. Thus when a bank " lends " to a 
customer, it really buys that customer's note, i.e., buys 
(for present cash) the right to receive a sum of money in 
the future. In the same example the customer or " bor- 
rower " is really a seller of future income for present cash; 
he sells his note which is a promise of a future payment. 
In short, every so-called " loan " is merely an exchange of 
present money for future money. These two moneys are, 
of course, not the same; so that only by a fiction is the 
original money " lent " and afterward '' returned." The 
original money is not actually lent but absolutely trans- 
ferred, never to be actually returned, but simply to be 
replaced by other money. 

By selHng some property rights and buying others it is 
always possible to transform one's income-stream at will, 
whether the transformation be in respect to distribution 
in time or in respect to certainty. Thus, if a man buys 
an orchard, he is providing himself with future income 
in the use of apples. If, instead, he buys apples, he is 
providing himself with similar but more immediate income. 
If he buys " securities," he is providing himself with 
future money, convertible when received into J&nal or 
enjoyable income. If his security is a share in a mine, his 
income-stream is less lasting, though it may be larger, 
than if the security is stock in a railway. 

Purchasing the right to remote enjoyable income is called 
investing; purchasing the right to immediate enjoyable 
income is called spending. The antithesis between " spend- 
ing " and " investing " rests upon the antithesis between 
immediate and remote income. The adjustment between 



396 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

the two determines the distribution in time of one's in- 
come-stream. Spending increases immediate income, but 
robs the future, whereas investing provides for the future 
to the detriment of the present. 

From what has been said it is clear that by buying and 
selling property an individual may change the conformation 
of his income-stream precisely as though he were specifically 
lending or borrowing. Thus, if a man's original income- 
stream consists of $1000 this year and $1500 next year, 
and if, selling this income-stream, he buys with the proceeds 
another income-stream yielding $1100 this year and $1395 
next year, he has not, nominally, borrowed $100 and repaid 
$105, but he has done what amounts to the same thing — 
increased his income-stream of this year by $100 and 
decreased that of next year by $105, the $100 being the 
modification produced in his income for the first year by 
selling his original income-stream and substituting the 
second one, and $105 being the reverse modification in 
next year's income. 

§ 3. Futility of Prohibiting Interest 

We may now note that interest taking cannot be pre- 
vented by prohibiting loan contracts. To forbid the par- 
ticular form of sale, called a loan contract, would leave 
possible other forms of sale, and, as has been shown, the 
valuation of every property right involves interest. If the 
prohibition should leave individuals free to deal in bonds, 
it is clear that virtually they would be still borrowing and 
lending, but under the name of " sale " ; and if " bonds " were 
tabooed, they could merely make the slight change to "pre- 
ferred stock." It can scarcely be supposed that any pro- 
hibition of interest-taking would extend to the prohibition 
of all buying and selling ; but as long as buying and 
selling of any kind were permitted, the virtual effect of 
lending and borrowing would be retained. The possessor 



Sec. 3] DETERMINATION OF THE RATE OF INTEREST 397 

of a forest of young trees, not being able to mortgage their 
future return, and being in need of an income-stream of a less 
deferred type than that receivable from the forest itself, 
would simply sell his forest, and with the proceeds buy, 
say, a farm with a uniform flow of income, or a mine with 
a decreasing one. On the other hand, the possessor of a 
capital which is depreciating, that is, which represents an 
income-stream great now but steadily declining, and who 
is anxious to " save " instead of " spend," would sell his 
depreciating wealth and invest the proceeds in some such 
instrument as the forest already mentioned. 

It was in such ways, as, for instance, by " rent-purchase," 
that the medieval prohibitions of usury were rendered 
nugatory. Practically, at the v/orst, the effect of restrictive 
laws is simply to hamper and make difficult the finer 
adjustments of the income-stream, compelling would-be 
borrowers to sell wealth yielding distant returns instead of 
mortgaging it, and would-be lenders to buy the same, instead 
of lending to the present owners. It is conceivable that 
" explicit " interest might disappear under such restrictions, 
but " implicit " interest would remain. The young forest sold 
for $10,000 would bear this price, as now, because it would be 
the discounted value of the estimated future income ; and 
the price of the farm bought for $10,000 would be determined 
in like manner. The rate of discount in the two cases must 
tend to be the same, because, by buying and selling, the 
various parties in the community would adjust their rates of 
impatience to a common level — an implicit rate of interest 
thus lurking in every contract, though never specifically ap- 
pearing therein. Interest is too omnipresent a phenomenon 
to be eradicated by attacking any particular form ; nor would 
any one undertake it who perceived the substance as well as 
the form. In substance, the rate of interest represents the 
terms on which the earlier and later elements of income- 
streams are exchangeable against each other. Interest can 
never disappear until present and future dollars will exchange 



398 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

at par. This would imply that human beings were no longer 
impatient, but considered it no hardship to wait indefinitely. 
We have hitherto supposed, for simplicity, that the in- 
come from each instrument is fixed in size and distribution 
in time. But often the same article may be used in any 
one of several ways producing any one of several different 
income-streams. In such a case the owner merely chooses 
the particular way which gives the capital the highest value. 
Since any man's income may be transformed as to its dis- 
tribution in time by the process of borrowing and lending 
or buying and selHng, he need not be deterred from select- 
ing an income by an inconvenient distribution in time. He 
can choose it exclusively on the basis of maximum present 
value and later correct any inconvenience of its distribution 
in time by borrowing and lending or buying and selling. 

§ 4. Clearing the Loan Market 

We have seen that from the standpoint of the individual, 
when a rate of interest is given, he will adjust his rate of 
impatience to correspond with that rate of interest. 

For him the rate of interest is a relatively fixed fact, 
since his own rate of impatience and resulting action can 
affect it only infinitesimally. All he can do is to adjust his 
rate of impatience to the rate of interest as he finds it. For 
society as a whole, however, these rates of impatience deter- 
mine the rate of interest. This corresponds to what was 
said as to the determination of prices. We have seen that 
each individual regards the market price, say, of coal, as 
fixed, and adjusts his marginal desirability or undesirability 
to it; whereas, for the entire market, we know that these 
marginal desirabilities and undesirabilities fix the price of coal. 
In the same way, while for the individual the rate of interest 
determines the rate of impatience, for society the rates of 
impatience of the individuals determine the rate of interest. 
The rate of interest is simply the rate of impatience upon 



Sec. 4] DETERMINATION OF THE RATE OF INTEREST 399 

which the whole community may concur in order that the 
market of loans may be exactly cleared. Supply and de- 
mand will work this out. 

To put the matter in figures : if the rate of interest is set 
very high, say twenty per cent, there will be relatively few 
borrowers and many would-be lenders, so that the total 
extent to which would-be lenders are wilHng to reduce their 
income-streams for the present year for the sake of a much 
larger future income will be, say, $100,000,000; whereas, 
those who are willing to add to their present income at the 
high price of twenty per cent interest will borrow only, say, 
$1,000,000. Under such conditions the demand for loans 
is far short of the supply, and the rate of interest will there- 
fore go down. At an interest rate of ten per cent, the present 
year's income offered as loans might be $50,000,000, and the 
amount which would be taken at that rate only $20,000,000. 
There is still an excess of supply over demand, and interest 
must needs fall further. At five per cent we may suppose 
the market cleared, borrowers and lenders being willing to 
take or give, respectively, $30,000,000. In like manner it 
can be shown that the rate would not fall below this, as in 
that case it would result in an excess of demand over supply, 
and cause the rate to rise again. 

Thus the rate of interest is the common market rate of 
impatience for income, as determined by the supply and 
demand of present and future income. Those who are 
very impatient strive to acquire more present income at 
the cost of future income, and tend to raise the rate of 
interest. These are the borrowers, the spenders, the buyers 
of goods which afford immediate gratification, the sellers 
of property yielding remote income, such as bonds and 
stocks. On the other hand, those who — being relatively 
patient — strive to acquire more future income at the 
cost of present income, tend to lower the rate of interest. 
These are the lenders, the savers, the investors. 

The mechanism just described will not only result in a 



400 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

rate which will clear the market for loans connecting the 
present with next year, but, applied to exchanges between 
the present and the remoter future, it will make similar 
adjustments. While some individuals may wish to ex- 
change this year's income for next year's, others wish to 
exchange this year's income for that of the year after next, 
or for income several years in the future. The rates of 
interest for these various periods are so adjusted as to clear 
the market for all the periods of time for which contracts 
are made. That is, supply and demand must be equal, so 
as to clear the market for every period of time. 

§ 5. The Conditions Determining the Rate of Interest 

We have sketched the main principles determining the rate 
of interest. Some have not been mentioned save by im- 
plication. In summary we may say that the rate of inter- 
est, considered independently of fluctuations in the monetary 
standard, is determined by six conditions. Those which we 
have above considered and explained are the following three : 
(i) the dependence of impatience upon prospective income — 
its size, distribution in time, and uncertainties; (2) the 
tendency of the rates of impatience for different individ- 
uals to seek a common level in the resulting rate of 
interest; (3) the fact that supply and demand must be 
equal so that the modifications in the income-streams of 
individuals, through buying and selling, or borrowing and 
lending, must " clear the market." 

Of the remaining three determining conditions the most 
important may be stated in the following form : (4) of all 
the optional uses to which a man may put his capital he 
will choose that one which at the market rate of interest 
makes the present value of his capital the largest possible. 
Thus a farmer may have the option of using a certain 
piece of land as wheatland or as woodland. If he uses 
it as wheatland, he can get an income from it every year ; 



Sec. s] determination OE THE BATE OF INTEREST 40I 

but if he plants a young forest on it, he must wait per- 
haps a generation before receiving any return. To 
compare the relative merits of these two uses of the land, 
he will need to calculate, as well as he can, the total 
present values of the incomes he would get in the two 
ways. If he reckons that the present value of the future 
income he can get by growing wheat is about $10,000, but 
that the present value of the future income he can get by 
growing timber is $12,000, he will prefer to grow timber. 
Evidently these calculations of present value can be made 
only by employing a rate of interest, and, if the rate of 
interest falls, the comparison may be reversed; timber- 
growing might then become more profitable than wheat- 
growing. Thus the farmer's decision as to which of the 
optional uses of his capital is the best will depend, in 
part, on the rate of interest. Reciprocally the rate of 
interest in the community will depend in part on the 
choice of uses of capital. Thus, if a fall in the rate of 
interest leads many people to abandon wheat-growing in 
order to take up the timber business, this shifting of part 
of the income of the community from the immediate to 
the remote future will tend to check the fall in the rate 
of interest on the principle already explained — that an 
increase of a remotely future income increases human im- 
patience. To be more specific, if a fall in the rate of 
interest makes timber-growing pay, where before it was 
unprofitable as compared to wheat production, then many 
of the farmers who turn to timber will need to borrow 
money while they are waiting for their slow-growing 
crop. They will therefore add to the demand for loans, 
and tend to raise the rate of interest. Thus we see that 
the choice between different uses of capital is one of the 
influences determining the rate of interest. 

The remaining two conditions are very obvious ones ; one 
condition being that (5) what is borrowed at any time by 
some persons equals what is loaned at that time by other 



402 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

persons, and the other condition being that (6) what any 
person borrows at one time must be repaid by that person 
at another time with interest at the market rate. 

These six conditions would fully determine the rate of 
interest under the assumption we have made of a perfect 
loan market. But in practice these conditions are some- 
what modified. For instance, the last or sixth condition 
(that the loan is to be repaid) is not always actually met, 
and the fear that it may not be met affects the rate of 
interest and often decides whether at the outset a loan 
shall be made or not. Some sort of security is required 
for almost every loan. Here, as in other instances, the 
element of risk is intertwined with the rate of interest. 

Again, the second condition (that the degrees of impa- 
tience of all persons become equal to the rate of interest) 
may not be fully met ; for a would-be borrower may not 
be able (owing to lack of security satisfactory to the lender) 
to secure a large enough loan to reduce his impatience to 
equality with the market rate of interest. Or he may be 
affected by laws restricting loans. Those thus shut out 
of the loan market will continue to have an impatience for 
income higher than the market rate of interest. 

Again, the fourth condition (that the use of one's capi- 
tal chosen will be that use of which the present value is 
greater than the present value of any rival use) is not 
always met, either because the owner is mistaken in his 
forecasts or because he is unable to obtain a loan by which to 
finance his choice. For instance, certain land may be worth 
most as timberland and yet actually used as grazing land, be- 
cause the owner cannot provide by loans or otherwise for 
the lean years which must pass while the timber is growing. 

One result of these and other imperfections in the loan 
market is that there are really many, rates of interest 
instead of one rate only. One rate, or rather group of 
rates of interest, is that realized on bonds ; another is that 
used in short-time bank loans; a third, that in "call" 



Sec. s] determination OF THE RATE OF INTEREST 403 

loans. Perhaps the most representative rate of interest is 
the rate on two or three months' loans at banks on indorsed 
notes of merchants called " commercial paper." 

Another result of the imperfections of the loan market 
is that the minor fluctuations in any particular rate of in- 
terest are more often due to varying imperfections of the 
market adjustment than to variations of income, human 
impatience, and the other factors enumerated as the fun- 
damental conditions determining the rate of interest. For 
instance, the rate of interest on bank loans varies from 
time to time with the changes in the ratio of reserves to 
deposits, especially if there be a legal requirement as to 
this ratio. A bank may refuse a loan to avoid increasing 
its deposits (in relation to reserves) above the legal ratio 
or, before this becomes necessary, it may raise its rate 
in anticipation. Thus the Bank of England raises its 
rate when necessary to "protect" its reserve. The daily 
variations in bank rates are usually due more to the need 
of readjusting the ratio of reserves to deposits than to 
changes in its customers' impatience or in their incomes. 

But in the long run the rate of interest is a fairly 
faithful register of human impatience as modified by 
mutual loans and borrowings in conformity with the six 
conditions mentioned. While the surface causes men- 
tioned in the preceding paragraph are necessary to explain 
slight local variations of interest as between New York 
and Boston, or to explain slight daily or monthly changes 
of interest rates by a fraction of one per cent, the differ- 
ences in human impatience in incomes and in price move- 
ments are the underlying influences which explain why the 
rates in America or China are several per cent higher than 
in England or Holland, and why the rates in one epoch of 
history are two or three times as high as in some other 
epoch. In short, interest rates are like the ocean, the 
level of which is slightly and temporarily influenced by 
winds, but more fundamentally by great tidal forces. 



404 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

§ 6. Historical Illustrations 

We have now completed our study of the causes deter- 
mining the rate of interest. If they are correct, we should find 
that the rate of interest is low (i) if in general the people are 
by nature thrifty, farsighted, self-controlled, or thought- 
ful for the future welfare of their children, or (2) if they have 
large or descending income-streams ; and that it is high (i) 
if the people are shiftless, shortsighted, impulsive, selfish, 
or (2) if they have small or ascending income-streams. 

History shows that facts accord with these conclusions. 
The communities and nationahties which are most noted 
for the quahties mentioned — foresight, self-control, and 
regard for posterity — are probably Holland, Scotland, 
England, and France. Among these people interest has been 
low. Moreover, they have been money lenders ; they have 
the habit of thrift or accumulation, and their instruments 
of wealth are in general of a durable kind. 

On the other hand, among communities and peoples noted 
for lack of foresight and for neghgence with respect to the 
future are China, India, Java, the negro communities in 
the Southern states, the peasant communities of Russia, 
and the North and South American Indians, both before 
and after they had been pushed to the wall by the white 
men. In all of these communities we find that interest is 
high, that there is a tendency to run into debt and to dis- 
sipate rather than accumulate capital, and that their dwell- 
ings and other instruments are of a very flimsy and perishable 
character, built for immediate, not remote, gratifications. 
This is true even where, as in China, the people are 
industrious. Industry without patience wiU result in hard 
work, but this work will be for immediate and not remote 
gratifications. 

These examples illustrate the effect on the rate of in- 
terest of differences in human nature. We now turn to 
illustrations of differences in the distribution in time of 



Sec. 6] DETEEMINATION OP THE BATE OF INTEEEST 405 

incomes. The most striking examples of increasing income- 
streams are found in new countries. It may be said that the 
United States has almost always belonged to this category. 

In America we see exemplified on a very large scale the 
truth of the theory that a rising income-stream raises, and 
a falling income-stream depresses, the rate of interest, or 
that these conformations of the income-stream work out 
their effects in other equivalent forms. A similar causation 
may be seen in particular localities in the United States, 
especially where changes have been rapid, as in mining 
communities. In California, in the two decades between 
1850 and 1870, following the discovery of gold, the income- 
stream of that state was increasing at a prodigious rate. 
During this period the rates of interest were abnormally 
high. The current rates in the " early days " were quoted 
at one and one half to two per cent a month. " The thrifty 
Michael Reese is said to have half repented of a generous 
gift to the University of California, with the exclamation, 
'Ah, but I lose the interest,' a very natural regret when in- 
terest was twenty-four per cent per annum." After railway 
connection in 1869, Eastern loans began to flow in. The 
decade 18 70- 1880 was one of transition during which the 
phenomenon of high interest was gradually replaced by the 
phenomenon of borrowing from outside. The residents of 
California were thus able to change the distribution in time 
of their income-streams. The rate of interest consequently 
dropped from eleven per cent to six per cent. 

The same phenomena of enormous interest rates were 
also exemplified in Colorado and the Klondike. There were 
many instances in both these places during the transition 
period from poverty to affluence, when loans were contracted 
at over fifty per cent per annum, and the borrowers regarded 
themselves as lucky to get rates so " low." In general the 
pioneer is willing to pay a high rate of interest so long as 
he cherishes the " great expectations " characteristic of new 
countries. 



4o6 ELEMENTARY PRINCIPLES OF ECONOMICS IChap. XXII 

§ 7. Interest and Prices 

We have seen that the rate of interest is not a mere tech- 
nical phenomenon, restricted to Wall Street and other 
" money markets," but that it permeates all economic re- 
lations. It is the link which binds man to the future and 
by which he makes all his far-reaching decisions. 
.' The rate of interest is itself a sort of price and plays a 
central role in the theory of other prices. It operates in 
the determination of the price of wealth, property, and bene- 
fits. It enters into the price of securities, real estate, and 
commodities, as well as into rent, wages, and the value of all 
" interactions." As was shown in previous chapters, the 
price of any article of wealth or property is equal to the dis- 
counted value of its expected future benefits. If the value of 
these benefits remains the same, a rise or fall in the rate of 
interest will cause a fall or rise respectively in the value of 
all instruments of wealth. The extent of this fall or rise 
will be the greater, the farther into the future the benefits 
of wealth extend. 

As to the influence of the rate of interest on the price of 
benefits, we first observe that benefits may be interactions 
or satisfactions. The value of interactions is derived from 
the succeeding future benefits to which they lead. For 
instance, the value to a farmer of the benefits of his land in 
affording pasture for sheep will depend upon the discounted 
value of the benefits from the flock in producing wool. The 
value of the wool output to the woolen manufacturer is in 
turn influenced by the discounted value of the output of 
woolen cloth to which it contributes. In the next stage, the 
value of the production of woolen cloth will depend upon 
the discounted value of the income from the production of 
woolen clothing. Finally, the value of the last named will 
depend upon the expected income which the clothing will 
bring to its wearers — in other words, upon the use of the 
clothes. 



Sec. 7] DETERMINATION OF THE RATE OF INTEREST 407 

Thus the final benefits, consisting of the use of the clothes, 
will have an influence on the value of all the anterior benefits 
of tailoring, nianufacturing cloth, producing wool, and 
pasturing sheep, while each of these anterior benefits, when 
discounted, will give the value of the respective capital 
which yields it; namely, the clothes, cloth, wool, sheep, 
and pasture. We find, therefore, that not only all articles 
of wealth, but also all the " interactions " which they render, 
are dependent, for their value, upon final enjoyable uses, 
and are linked to these final uses by the rate of interest. 
If the rate of interest rises or falls, this chain will shrink or 
expand. The chain hangs, so to speak, by its final link of 
enjoyable benefits, and its shrinkage or expansion will there- 
fore be most felt by the links most distant from these final 
benefits. At the close of Chapter VI it was shown that a 
change in the rate of interest only slightly affects the value of 
a suit of clothes, the benefits from which are soon realized, 
but greatly affects the value of land, the benefits of which 
. stretch out into the distant future. So a change in the rate 
of interest will affect but slightly the price of making clothing 
since the final benefits from making clothing will occur in a 
short time, but it will affect materially the price of pasture 
for sheep since the final benefits from the pasturing will re- 
quire a long time. 

A study, therefore, of the theory of prices involves (i) a 
study of the laws which determine the prices of final 
benefits on which the prices of anterior interactions de- 
pend; (2) a study of the prices of these anterior inter- 
actions, as dependent, through the rate of interest, on the 
final benefits ; (3) a study of the price of capital-instru- 
ments and capital-property as dependent, through the rate 
of interest, upon the prices of their benefits. The first 
study, which seeks merely to determine the laws regulat- 
ing the price of final benefits, is relatively independent 
of the rate of interest. The second and third, which 
seek to show the dependence on final benefits of the anterior 



4o8 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXII 

benefits and of the capitals which bear them, involve and 
depend upon the rate of interest. 

In the theory of prices we found that the ultimate elements 
supplied and demanded were satisfactions and efforts. But 
we now see that there is involved in each price another special 
price, viz., the rate of interest. Without the rate of interest 
we may only compare simultaneous satisfactions or efforts. 
With it we may compare all that exist. By means of the rate 
of interest any future satisfaction or effort is discounted, and 
thus translated into terms of present value. It enables us 
to pause at every step and appraise the interactions and cap- 
ital which anticipate future satisfactions. In other words, 
by it we capitalize income and form our capital accounts. 

Interest, then, is the universal time-price, Unking im- 
pending and remote satisfactions, or efforts, or both. It is 
literally the previously missing link necessary for a complete 
comparison of efforts and satisfactions at all points of time. 

The study of the rate of interest, therefore, rounds out 
and completes our study of prices. 

§ 8. Classification of Price Influences 

We may now fitly review the theory of prices by enumer- 
ating the various possible causes which might decrease the 
price of, let us say, pig iron in New York. Its price might 
fall for any one or more of the following reasons : — 

I. A rise in the marginal desirability of money due either to 

A. A rise in the purchasing power of money through 

1. A decrease in money or deposit currency, or 

2. A decrease in their velocities, or 

3. An increase in the volume of trade ; or to 

B. An impoverishment or reduction of incomes. 

II. A fall in the marginal desirability of pig iron dtie either to 

A. An increase in the amount of pig iron used, through 

I. Importation of pig iron from other places where its 
price is lower than in New York, or 



Sec. 8] DETERMINATION OF THE RATE OF INTEREST 409 

2. Short sales of pig iron for future delivery in ex- 

pectation of a fall of price, thus releasing to pres- 
. ent use such stocks as would otherwise be held 
over for the future, or 

3. A decrease in its cost by 

a. A saving of waste, 

b. A saving of labor, 

c. A decrease in the price of iron ore or other 

prices entering into its cost, 

d. An increase in the price of by-products, or 

4. A trade war ; or to 

B. A fall in the marginal desirability of a given quantity of pig 
iron, through 

1. A decrease in the price of iron products through a 

decrease in the marginal desirability of the satis- 
factions they yield, because of 

a. An increase in their amount, 

b. A change in fashion, etc., or 

2. An increase in substitutes for pig iron, or 

3. A decrease in complementary articles, or 

4. An increase in the rate of interest whereby the value 

of pig iron is obtained (by discounting the value 
of iron products) through an increase in the 
marginal rates of impatience, 
a. From a change in human nature 
(i) By decreasing foresight, 

(2) By decreasing self-control, 

(3) By increasing shiftless habits, 

(4) By decreasing regard for posterity, or 
h. From a change in incomes 

(i) By shifting their distribution in time 
toward the futiu-e. 

(2) By reducing their size, 

(3) By increasing their uncertainties. 

Back of these causes lie other causes, multiplying end- 
lessly as we proceed backw^ard. But if we trace back all 
of these causes to their utmost limits, they will all resolve 
themselves into changes in the marginal desirability or 
undesirability of satisfactions and of efforts, respectively, 
at different points of time, and in the marginal rate of 
impatience as between any one year and the next. 



CHAPTER XXIII 

INCOME FROM CAPITAL 

§ I. Distribution according to Agents of Production and 
according to Owners 

We began this book with a study of economic accounting. | 
In this way we obtained a bird's-eye view of the whole field 
of economic science. At that time we had to take ready- 
made the material for constructing our capital and income 
accounts. This material consisted of the values of various 
items, whether of capital or of income. These values are, 
in each case, the product of two factors, the quantity of 
the good valued and the price of that good. We have 
now finished the study of one of these two factors, price, 
and there remains for us only the study of the other, 
quantity. We have explained how the price of instruments, 
property rights, and benefits, which enter into capital and 
income accounts, is determined. We have still to explain 
how the quantities of instruments, property rights, and 
benefits are determined. What determines^ for instance, 
the quantity of wheat which a given wheat field will pro- 
duce ; what determines the quantity of the wheat fields ; 
what determines the quantities of human beings on a given 
area ; what determines the quantities of the necessities, 
comforts, luxuries, and amusements of life which a nation 
or an individual possesses? Once we can explain these 
quantities, we have completed our task of explaining 
economic quantities, prices, and values. We shall then 
be able to explain — at least in general terms — why, 
for instance, the quantities and values of the capital or 
income, in capital-accounts or in income-accounts, of some 

410 



Sec. i] INCOME FROM CAPITAL 411 

communities or individuals are so great, and those of others 
so little ; why the benefits flowing from one piece of land 
are so great, arid from another so small ; and so forth. 

Our purpose is not so much to reach absolute, as rela- 
tive, results. We care less about the absolute population 
of the globe than about population relatively to land. We 
care less about the world's total yield of wood than about 
the yield per capita, or per acre ; less about the total yield 
of cloth than about the yield per capita or per loom. In 
general, we care less about the total amount of the yield 
from the aggregate of any kind of capital than about the 
yield per capita and per unit of that particular kind of 
capital. 

Our present search, then, is for relative quantities, or 
for relative values. There are two sets of such quantities, 
or of such values, which are of special importance in our 
study. One is the quantity and value of income per 
unit of capital which yields the income, and the other 
is the quantity and value of income and of capital per 
human being who owns the capital and the income from it. 
The first represents the distribution of income relatively to 
the agents which produce it. The second represents the 
distribution of income and of capital among their owners. 
The study of the first will occupy our attention in this and 
the following chapter. In the present chapter we shall 
consider income produced by capital (in its narrow sense, 
i.e., exclusive of human beings) ; in the following chapter we 
shall consider income produced by labor, or human beings. 

It is well to bear in mind that income is usually a joint 
product of labor and capital; for labor and capital are 
usually " complementary" to each other, each helping the 
other to produce the joint product of both. It is con- 
venient, however, in thought to separate the two. 

Our immediate task, therefore, is to study the ratios of 
income to capital. We take up first the ratio of the 
value of the income to the quantity of capital which yields it. 



412 ELEMENTAHY PRINCIPLES OP ECONOMICS [Chap. XXIII 

This ratio is called rent. Rent as here used means the 
value of income yielded per physical unit of capital. Thus, 
land may yield a "rent" of $io a year per acre; or 
houses, of $1000 a month per house. The concept of rent 
here employed is somewhat broader than the popular con- 
cept ; for it includes, besides the rent explicitly named in 
a lease between landlord and tenant, the rent which is 
implicit when there are not two persons involved, but 
landlord and tenant are one and the same person. Explicit 
rent is rent in the usual and strict sense of the term. 
Implicit rent is often called capitalists' profits. That is, 
rent is exphcit when the income is stipulated; it consists of 
a definite payment for the use of the instrument. This 
occurs when the owner of the instrument sells its use, 
i.e., "lets" or "rents" it to another person and gets 
from it a definite money-income. Implicit rent occurs 
when the income is not stipulated, and therefore can 
only be appraised. When a landlord rents his land to 
a tenant for $1000 a year, the rent is explicitly $1000 a 
year ; when, instead, he works the land himself and makes 
from it an income which consists in the production of 
crops, the rent is only implicit. Before he can state its 
amount he must appraise the crops, including both those 
portions which he sells and those consumed by himself and his 
family. If he appraises the crops and other benefits which 
he receives from the land at $3000 and the costs at $2000, his 
net income is $1000, and therefore his implicit rent is $1000. 
A " rented " house bears explicit rent, but a house lived 
in by the owner has an implicit rent, i.e., whatever benefits 
it yields to the owner reckoned over and above its costs. 

The most common kind of instruments explicitly rented is 
real estate, although many other more or less durable com- 
modities, such as furniture, horses and carriages, telephones, 
pianos, typewriters, and even clothing, may sometimes be 
explicitly rented. 

Explicit rent, being stipulated, is usually ^ice^i and certain 



Sec. 2] INCOME FROM CAPITAL 413 

— at least for all practical purposes ; implicit rent, on the 
other hand, is variable and uncertain. 

§ 2. The Rent of Land 

Although a piece ^f real estate is usually rented as a 
whole, including both land and improvements thereon, 
sometimes the land and the improvenients are rented 
separately. Thus a man may lease an empty building 
lot and then make a supplementary contract to lease a 
building to be erected thereon by the landlord. The 
rent of land separately is called ground rent. Even 
when ground rent is not separated in contract, it may, 
for purposes of discussion, be separated in thought; so 
that all land bears ground rent, either explicit or implicit. 
Ground rent has been the subject of a vast amount of dis- 
cussion. It underlies, for instance, " the single tax " propa- 
ganda, which advocates that taxes shall be laid on ground 
rent alone. 

There are two important peculiarities of land which are 
shared by very few other instruments. One of these peculiar- 
ities is that, practically speaking, the land in the world is 
fixed in quantity. Except by filling in tidal lands, as in 
Holland, and in a few other instances, we cannot add 
to the world's acreage ; nor can we subtract from it. It 
is true that in some cases we may materially increase its 
productivity by irrigation, fertilizing, etc., on the one 
hand, or decrease it by erosion and exhaustion of the soil 
and other abuses on the other. These alterations in land 
are more important than has sometimes been recognized, 
and their importance is increasing. For the present, 
however, we shall assume a community in which the 
land remains unchanged, both in quahty and quantity, 
possessing, as Ricardo expressed it, " natural and inde- 
structible powers of the soil." For our purpose it is enough 
to assume that the land is indestructible. Whether it be 



414 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XXIII 

natural or not is a matter of indifference ; precisely the same 
principles of valuation apply to the land which was wrested 
by our ancestors from the wilderness as apply to land which 
was solely a gift of nature. 

The second peculiarity of land is that its different 
qualities cannot, in most cases, be as fully separated and 
classified as the different quaUties of most other kinds of 
wealth. We can sort wool, for instance, into different 
kinds or categories and label and sell each kind separately. 
The same is true of wheat or coffee or automobiles. Each 
separate kind is then regarded as a separate commodity. 
But it is not practicable to sort different kinds of land, 
because the different kinds are inextricably intermingled 
and cannot be moved apart, and because one element in 
the character of land — ■ its situation — differs materially 
with every individual piece of land. Any classification 
which would really " standardize " lands, — that is, make 
the lands in any one class sufficiently homogeneous as to 
bear substantially the same price per acre, — would have 
to be too minute a classification to be of any practical 
value. In the case of ordinary commodities which are 
"standardized" there exists but one price for each cate- 
gory. But the price of land differs with each individual 
piece, varying almost continuously from nothing up to 
$870 a square foot, the record recently set in New York 
City. 

The prices of land, for the most part, follow the 
principles of substitutes or competing articles. It is 
true that the various lands are not all substitutes. A 
city building site is not a substitute for wheat land, nor 
is it a substitute for forest or mineral lands. But here, 
again, for the sake of simplicity, we first consider only 
wheat lands, and shall assume that all these wheat lands 
are incapable of any other product and differ only as to 
productivity of wheat. We therefore assume : — 

(i) That these wheat lands are fixed in quantity. 



Sec. 2] 



INCOME PROM CAPITAL 



415 



(2) That they differ in quality {i.e., productivity) by 
continuous gradation from very fertile to very infertile 
lands, each fixed and invariable as to wheat productivity 
and having no other product. 

(3) That the cost of tilHng each acre is likewise fixed and 
invariable, say $10. 

(4) That the lands are substantially equal in accessibility 
(thus being in a common land-market and contributing 
wheat to a common wheat-market). 

Let us suppose, as represented in Figure 46, an island 
fulfilling the three conditions above mentioned. In order 




Fig. 46. 



further to simplify the picture, let us suppose the most 
fertile land situated in the center capable of producing 25 



41 6 ELEMENTARY PEINCIPLES OF ECONOMICS [Chap. XXIII 

bushels of wheat per acre per year, and the other lands 
arranged around it spiral fashion in the order of descend- 
ing productivity. If there is a superabundance of the 
25-bushel-per-acre land so that it can be had merely for the 
trouble of occupying it, and there is no prospect that any 
inferior grades will ever need to be used, the land will be, 
like air, without value, and will yield no rent. The reason 
is that the supply of land of the first quality, which 
may be had free, exceeds the amount demanded. We 
have seen that under such extreme conditions of supply 
and demand the price is low. No one will pay for the 
use of land when, without traveling farther than across 
a field, there is plenty of equally good land to be had 
for nothing. The wheat, however, will have a price equal, 
as previously explained, to its marginal desirability meas- 
ured in money and also to its marginal cost measured in 
money. But we have already assumed that this cost is 
fixed for each grade of land and is the same for every bushel. 
Consequently the price of wheat is in this case simply equal 
to the marginal cost of producing the wheat. For, if sellers 
should try to sell above this cost, buyers would prefer to 
grow the wheat at that cost themselves. Hence the value of 
a bushel produced on an acre of the first-grade land is only 
just equal to the cost of producing wheat there, which, at $10 
per acre for 25 bushels, is $10 -r- 25, or 40 cents per bushel. 
But if the population so changes as to create a demand 
for wheat which cannot be suppHed from the most fertile 
land, some of the next grade of land will be used, yielding 
24 bushels per acre. What was before true of only the 
first-grade land will then be true of this second-grade land. 
It will be valueless, and will yield no rent. But no longer 
will this be true of the first-grade land. It will have a 
value and yield a rent. For there will be a rise in the 
price of wheat. The price will still be equal to the mar- 
ginal cost, hut now the marginal cost is the cost of producing 
a bushel on the second-grade land. The value of the 24 



Sec. 2] INCOME FROM CAPITAL 417 

bushels produced on this land will now be equal to the 
cost of producing 24 bushels on that land, i.e., $10. The 
marginal cost is, therefore, $10 -r- 24, or 41.6 cents a bushel. 

But since there cannot be two prices for the same article 
in the same market, the price of the wheat produced on 
the first-grade land must be the same as that produced on 
the second grade. Consequently, the owners of the first- 
grade land now have a crop worth more than the cost of 
producing it, and can now, if they choose, obtain a rent for 
it equal to the excess, i.e., one bushel per acre ; for a tenant 
paying the equivalent of one bushel per acre would have 
24 bushels for himself, which is exactly the same as he 
would get if he took up a claim for himself on the second- 
grade land; and if the landlord should attempt to charge 
more, he would lose his tenant, as the latter would then 
be better off on the second-grade land. If he charged less, 
he would be besieged by applications, and would put up 
his price. The market would be cleared by a rent of one 
bushel per acre. In money this is 41.6 cents per acre. If 
the owner does not rent his land to another, but enjoys the 
product himself, he is still said to obtain 41.6 cents an acre 
of implicit rent. 

If the population changes again so as to require a resort 
to the third-grade land, the price will be still higher, viz., 
$10 -r- 23, or 43 1 cents per bushel ; and the rent of the first- 
grade land will rise to equal the difference between its pro- 
ductivity and that of the third-grade land, viz., 2 bushels 
per acre or 2 x 43I cents, i.e., 87 cents per acre. Likewise 
the second-grade land will now bear a rent equal to its 
superiority over the third grade, viz., one bushel per acre, 
or 43^ cents. In the same way we may reckon the rent 
under other states of land-occupation. In each case the 
rent of any grade of land is the difference between its pro- 
ductivity and the productivity of the worst or marginal land 
occupied. If, for instance, the lowest grade of land occu- 
pied is that indicated in the table as having a productivity 



41 8 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XXIII 

of 9 bushels per acre, the rent of the first grade is now 25 — 
9, or 16 bushels per acre ; that of the second grade, 24 — 9, 
or 1 5 bushels per acre ; that of the next, 23 — 9, or 14 bushels 
per acre ; and so on down to the worst land, which bears no 
rent. Since the price of wheat is, in all cases, its cost of pro- 
duction on the worst, or no-rent land, it will now be $10 for 
9 bushels, or $1.11 per bushel. Therefore in money the rents 
of the various lands from the best to the worst will be: — 

16 X $1.11 or $17.76 per acre, 

15 X $1.11 or $16.65 per acre, 

14 X $1.11 or $15.54 per acre, 
etc. 

The last, worst, or no-rent land, is sometimes also called 
the " Ricardian acre " in honor of Ricardo, who first stated 
this doctrine of land rent. Its scientific designation is 
"marginal acre" ; that is, it is the last acre whose cultivation 
can be made to pay. This marginal land in a sense forms a 
standard by reference to which the rent of all other land 
may be measured, and the cost of producing wheat on this 
marginal land sets the price of wheat for all lands, — for 
there can be but one price of wheat in the same market. 

We have reached, then, two important results true under 
the conditions supposed, — 

(i) The price of wheat is equal to its cost of production on 
the margin of cultivation. 

(2) Ground rent of any land is the difference between the 
productivity of that land and the productivity of land on 
the margin of cultivation {i.e., the poorest land cultivated). 

With an increase of population, then, the price of wheat 
and the rent of wheat land will rise, and the owner of good 
land will become gradually wealthier merely through the 
increase in population. He receives an increase in rent ; 
and therefore the value of land — i.e., the capitalized or dis- 
counted rent — will increase also. This increase in the 
value of the land is sometimes called the " unearned incre- 
ment " because it is due to no labor on the part of the 



Sec. 2] INCOME FROM CAPITAL 419 

landowner. (It should be noted, however, that during the 
transition of rents from low to high, those who foresee a 
rise in rent will discount in advance the larger future rents ; 
not all so-called " unearned increments " are unexpected.) 

These conclusions hold absolutely under the conditions 
assumed. But in the actual world these conditions are 
never exactly realized. Instead, we find: — 

(i) Land is not absolutely fixed in quantity. 

(2) The productivity of any piece of land is not fixed, but 
varies from time to time both in kind and in degree, and this 
productivity will vary with the price of its product, e.g., 
wheat. 

(3) The cost of tilling land is not fixed, but varies with 
different land, and, indeed, as we shall presently show, is 
influenced by the price of the product. 

(4) Some lands are much more distant to reach and 
occupy than others and their product much more difficult 
to bring to market. 

(5) The land may be capable of more than the one use 
of wheat-growing, and a change in the price of wheat may 
shift the use to which certain lands are put. No theory of 
land rent is complete which assumes that the difference in 
quality among lands is merely a matter of different amounts 
of one product, like wheat. 

We have already discussed the first of these points and 
find it to be of Httle practical importance. The second is 
that the productivity of land is not solely a matter of natural 
fertility. This might be the case with some mineral springs 
or oil wells ; but in most cases each piece of land may be more 
or less intensively cultivated, and a rise in the price of wheat 
will stimulate wheat production on all lands, the better 
grades included. Thus, if the first grade produced 25 bushels 
when no other land was in use, it would, with more outlay, 
produce more than 25 bushels as soon as the next grade 
was in use; and the poorer the worst grade was, and 
the higher the price of wheat, the greater would be the 



420 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XXIII 

amount grown by those cultivating the superior grades of 
land. In other words, a change in the price of wheat would 
not only affect the amount of land under cultivation, but 
would affect also the intensity of cultivation of each piece 
of land. The productivity of each acre is not a constant 
quantity, but is indirectly dependent on the price. Each 
acre will be cultivated up to that degree of intensity at 
which the last dollar's worth of cost will barely repay itself. 
That is, not only is there a margin of cultivation as to 
acres — in other words, a last acre which it pays to culti- 
vate — but there is also a margin of cultivation for every 
acre, good or bad, i.e., the last degree of effort or cost 
which it pays to put forth on that acre. Each acre will 
be tilled until this marginal cost of tilling agrees with the 
market price as determined by the cost of production on 
the most inferior land. 

Again, as to the cost of tilling land per acre, this is by 
no means a constant quantity for all lands, both good and 
poor ; nor is it constant even for the same land. The cost 
of tilHng per acre may be either higher or lower on good 
land than on poor land ; and, as implied above, the cost 
on any land will vary with the price of the product, just 
as the product itself varies with the price. The farther 
cultivation is extended to poorer and poorer lands or the 
more intensively the same land is cultivated, the greater 
wUl be the marginal cost. This is the law of increasing 
cost • applied to agriculture. It is also often called " the 
law of diminishing returns" ; for to say that, as cultivation 
is either extended or intensified, the cost of producing a 
given amount of wheat continually increases is, turned 
about, evidently the same thing as to say that the 
amount produced at a given cost continually diminishes. 
In an absolutely correct theory the numbers expressing 
productivity in Figure 46 must be conceived as increas- 
ing slightly as the margin of cultivation is extended, 
and the numbers expressing cost will not be simply a con- 



Sec. 2] INCOME FROM CAPITAL 42 1 

stant $10 per each acre, but will differ among different 
kinds of land according as the soil is rocky or not resistant 
to the plow and harrow, level or uneven in surface, con- 
taining obstructions such as trees, or free of obstructions. 
Moreover the cost will not be invariable even for a given 
land but will increase slightly as the margin is extended. 

Again, lands differ so widely as to accessibility that 
tenants are reluctant to leave English lands, for instance, 
to take up lands in the Mississippi valley. A slight ad- 
vantage in the latter over the former will not suffice to 
produce emigration from the English to the American 
lands and to reduce the rents of the former. Only when 
the advantage is considerable will emigration ensue. The 
readjustments of population are therefore not as delicate 
as the readjustments of water between two connecting 
reservoirs seeking a common level. They resemble, rather, 
the readjustments of a viscous fluid like pitch which re- 
quires a considerable difference of level before the fluid 
will flow at all. The same viscosity applies in a less 
degree to the products of lands. These do not compete 
on even terms, for some lands are distant and others near 
the common market, and some have good and others poor 
transportation facilities. These differences are especially 
important in the case of bulky products such as hay which, 
for the reasons just given, differs very widely in price in 
different localities. 

While, therefore, the theory of rent as above given is 
correct under the ideal conditions assume^d, it is not abso- 
lutely correct under the actual conditions we find in the 
world. But the modifications necessary to make the 
theory of ground rent true to life are so slight as not 
materially to change the practical results. It still remains 
substantially true that the rent of any wheat land is equal 
to the difference between its productivity and the pro- 
auctivity of the worst wheat land under cultivation in the 
neighborhood. 



422 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

§ 3. Rent and Interest 

The principles of ground rent apply also to house rent, 
piano rent, or rent of any other kind, except that much 
greater divergencies from such stereotyped figures as we 
gave for ground rent will be necessary in these cases. In 
particular, houses, pianos, etc., are not essentially fixed in 
quantity, but their quantity will be changed according to 
their rent and their price (which is the discounted value of 
their rent). The difference, then, between the rent of land 
and the rent of other instruments is a difference in the 
character of the supply. The supply of land is relatively 
fixed ; other instruments are reproducible.^ 

It is important to understand this difference and also not 
to confuse it with a common fallacy that land rent alone 
is truly rent, and house rent and other rent are really 
interest. It is easy to see that land rent may be equal to 
interest on the capital-value of the land just as truly as 
house rent may be equal to the interest on the capital- 
value of the house. In that case both are rent and both 
are interest ; they are simply two different ways of measur- 
ing the same income-value. Rent is measured per unit 
of physical capital, as for instance per acre ; interest is 
measured per cent. That is, rent is income considered 
in relation to the quantity of the capital yielding it; it is 
expressed as so many dollars per acre or per piano or 
other rented unit of wealth. Interest is the same income 
considered relatively to the value of the capital yielding 
it ; it is expressed as so many cents of income on the dol- 

^ This practical difference between ground rent and other rent, such as 
house rent, has an important application in taxation. It is not within the 
scope of this book to consider problems of taxation. In treatises on tax- 
ation it is shown that a tax on ground rent falls on the landlord and does 
not appreciably affect the tenant, because it cannot affect the supply of 
land, which is practically fixed by nature ; whereas a tax on house rent is 
borne partly by the tenant, because it discourages house building and affects 
the supply of houses. 



Sec. 4] INCOME FROM CAPITAL 423 

lar of capital, i.e., as a simple percentage, such as five per 
cent. 

To illustrate, let us suppose a quantity of land — ten acres 
— to have a value of $1000, and that $50 a year is paid 
for its use. This $50 is both rent and interest. It is the 
rent on the ten acres and the interest on the $1000. The 
rent is $50 per year for 10 acres, or $5 per acre per annum. 
The interest is $50 per year for $1000, or five per cent per 
annum. In precisely the same way, let us suppose a qttan- 
tity of houses — ten houses — to have a value of $100,000, 
and that $5000 a year is paid for their use. This $5000 is 
both rent and interest. It is the rent on ten houses and 
the interest on $100,000. The rent is $5000 per year for 
ten houses, or $500 per house per annum, and the interest 
is $5000 per year for $100,000, or five per cent per annum. 

The erroneous belief that land bears only rent, and that 
other instruments bear only interest, is to a large extent 
responsible for the narrow definitions of capital which 
are so often given and which are so framed as specifically 
to exclude land. A true analysis justifies the usage of 
business men who apply the term " rent " as freely to in- 
come from houses as to income from land, and the term 
" interest " as freely to income from land as to income from 
houses. 

§ 4. Four Forms of Income : Interest, Rent, Dividends, 
and Profits 

If now we gather together what was said in regard to 
explicit and implicit rent and the relations between rent 
and interest, we shall see that there are four chief forms in 
which men receive income from capital. These are ordi- 
narily known as interest, rent, dividends, and profits. 
In order to distinguish them clearly, let us suppose four 
brothers, each of whom inherits a fortune of $ico,ooo. The 
first invests his $100,000 in a land company in one him- 



424 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

dred $1000 bonds at par bearing five per cent interest. 
He then receives $5000 a year, which is interest in the narrow 
or expHcit sense of the term. The next brother invests his 
$100,000 in a ranch of a thousand acres, which he rents to 
a tenant for $5 an acre. He then receives an income of 
$5000 a year, which is rent in the narrow and expKcit sense. 
The third brother invests his $100,000 in a hundred shares 
of stock in a land company, buying them at par, or $1000 
per share. This stock we shall assume jdelds him five per 
cent, and he receives an income of $5000 in dividends (also 
called profits). The fourth brother invests his $100,000 in 
a ranch of a thousand acres, which he proceeds to operate 
himself. Supposing that he succeeds in securing a net 
income of $5 per acre, he will be receiving $5000 a year of 
profits. Each of these brothers is receiving an income of 
$5000 a year from capital in the form of real estate ; but 
they are all receiving their income under different conditions. 
The four types of income may be arranged as follows : — 

(i) Interest per cent. (3) Dividends (or profits) per cent. 

(2) Rent per acre. (4) Profits per acre. 

In the upper line, namely for brothers (i) and (3), the in- 
come is expressed as a percentage of the value of the capital. 
In the lower line, namely, for brothers (2) and (4), the in- 
come is expressed per acre. As we have seen, either ex- 
pression can be translated into the other. 

Again the first column, namely for brothers (i) and 
(2), represents the explicit or assured income, while the 
second column, namely, for brothers (3) and (4), represents 
the implicit or uncertain income. The first two brothers 
have an assured or stipulated income of $5000. The last 
two have an uncertain or precarious income which, though we 
have supposed it to be $5000, may, and probably will, fluc- 
tuate from time to time. There is a fundamental difference 
between the first two and the last two brothers in regard 
to the risk involved. The first two are supposedly relieved 



Sec. 4] INCOME FROM CAPITAL 425 

of risk, some one else assuming the risks of managing the 
land of the company or of running the ranch, and guar- 
anteeing to these brothers a certain stipend of $5000 a 
year each. Corresponding to this fundamental difference 
in risk is a fundamental difference in variability. The in- 
comes of the first two brothers are regular; those of the 
last two are irregular. Where there are risks or chances 
to be taken there is irregularity of income as a conse- 
quence. 

It is evident that some one must assume these risks. 
Uncertainty attaches to the future product because we 
can never know absolutely the conditions as to weather, 
bhght, fire, labor conditions, etc. Nature never offers a 
perfectly safe investment. What is called a safe investment 
is always in the form of a contract between one man and an- 
other by which one man takes risks and guarantees another 
man against risks. Even then the guarantee is not perfect, 
so that the most " gilt-edged security " involves a slight 
element of risk, while in many cases Httle dependence can 
be placed upon a guarantee because of the unreHability of 
the person making it. 

Nevertheless, it remains true in a general way that ex- 
plicit income promised to the holder of a note or bond is 
comparatively certain, while the income to a stockholder is 
uncertain. Investors, therefore, are naturally divided into 
two groups : those who are unwilling to assume the risks 
of business, or bondholders, and those who are willing to 
assume these risks, or stockholders. Most modern enter- 
prises are financed by both of these two classes of investors, 
part, often half, being owned by the bondholders and the 
remainder by the stockholders. As we have seen in 
the study of capital accounts, the stockholders' share is the 
residuum after the value of all other obligations is de- 
ducted ; and this residuum acts as a sort of a buffer or 
guarantee that the assets shall cover the liabilities. The 
smaller the fractional part assumed by the stockholders, the 



426 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

less adequate is this margin or guarantee and the greater 
the risk of large losses to the stockholders or even of com- 
plete bankruptcy. Therefore, in any proper financiering of 
an industrial project, care should be taken to provide that 
enough of the first cost should be paid by stockholders to 
fully guarantee the bonds. Exactly what constitutes a safe 
proportion will depend on the particular circumstances of 
the business. Experience, however, has determined certain 
fairly definite proportions for stocks and bonds of different 
enterprises. These should be ascertained by the intending 
investor before entering into any particular project. 

The question now arises : What determines the rate at 
which the risk takers in a business, those who receive 
dividends and profits, shall be rewarded? Will all four 
brothers normally receive the same income? To this our 
answer is, first, that those who assume risk may receive 
either a larger or a smaller income than those who do not, 
and probably over a long period of time will receive a fluctu- 
ating instead of a steady income. Probably on the average 
the risk takers will receive a larger income than those 
guaranteed against risk ; for risk is, or should be, regarded 
as a burden and will not be undertaken unless the chance 
of unusually large returns outweighs the risk of unusually 
small ones. The daring spirits who assume the risk of 
embarking their capital in ships, railways, and other enter- 
prises and guarantee to their fellow-investors, the bond- 
holders, a fixed return, not only deserve, but in general 
receive, a higher return. Those who voluntarily assume 
risks, as the stockholder, do so not because they like the 
chance of taking risks, but because they hope in the long 
run to be sufl&ciently rewarded for so doing. They may, 
of course, be disappointed where bad luck has been un- 
usually persistent or where the investors have been unusu- 
ally sanguine and lacking in caution. 

At the extreme of incaution are the gamblers and reck- 
less speculators to whom a small chance of great gain out- 



Sec. 5] INCOME FROM CAPITAL 427 

weighs a great risk of moderate losses; and where men of 
this temperament predominate, as is often true in mining 
camps, the average profits or dividends are apt to be less 
than the interest and rent which the cautious, conservative 
investor receives. 

§ 5. Avoidance of Risk 

Uncertainty being regarded as an evil by practically all 
normal persons, there is a constant effort to avoid or 
reduce uncertainties of income. Not only do bondholders 
avoid risks by shifting them to other persons, but those 
who thus assume risks also strive to reduce them to a mini- 
mum. This they accomplish in various ways, of which the 
following are important : (i) by increasing their knowledge 
of the future, (2) by employing safeguards against mis- 
chances, (3) by insurance, (4) by speculative contracts, 
especially " hedging." We shall take these up in order. 

(i) Risk, being simply an expression for human ignorance, 
decreases with the progress of knowledge. The chief lines 
of progress in industry at the present time may be said to 
be those which tend to lift the veil which hides the future. 
Countless trade journals exist principally to enable their 
readers to forecast the future more accurately than they 
otherwise could. This the journals accomplish by supply- 
ing data as to past and present conditions, as well as by 
instructing their readers in the relations of cause and effect. 
Our government weather bureau supplies weather forecasts 
which somewhat reduce this form of uncertainty for the 
farmers. Government reports of crop conditions and infor- 
mation as to diseases of plants and animals are more impor- 
tant influences in the same direction. , Again the prediction 
as to the amount of ore to be obtained from a mine and 
the cost of obtaining it is to-day far less uncertain than ever 
before. Whereas formerly the mining prospect consisted 
of wild statements of the ore " in sight," and the time and 



428 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

cost required to mine it, to-day the graduate of a mining 
school can, through his knowledge of economic geology and 
metallurgy, make forecasts with some degree of certainty. 

(2) Safeguards of many kinds have been invented to 
reduce the risk of shipwreck, fire, explosion, burglary, etc. 
A modern ship is built in compartments as a safeguard 
against shipwreck ; fire escapes are a safeguard against loss 
of life by fire ; safety valves against explosions ; and bur- 
glar alarms and safety deposit vaults against burglary. 

(3) Insurance consists in consolidating risks, i.e., in off- 
setting one risk by another by consolidating in one insurance 
company a large number of chances. Relative certainty 
is, as it were, manufactured out of uncertainty. Insurance, 
unhke increase of knowledge and safeguards, does not 
directly decrease the risks for society as a whole, but by 
pooling these risks it has the effect of steadying the income 
of individuals and spreading the burden of risk more evenly 
over all. The owner of a house would receive, if it were 
not insured, a net annual income of, let us say, $500 until 
the house was burned, after which he would suddenly find 
himself without any house to have an income from ; whereas 
if he insures, he will be receiving annually an income slightly 
less than before because of the insurance premium he will 
have to pay ; but when a fire occurs, he will receive an 
indemnity enabling him to restore the house and continue 
his income almost unabated. The same method of steady- 
ing one's income is obtained by marine insurance, steam- 
boiler insurance, burglar insurance, plate-glass insurance, 
live-stock insurance, hail and cyclone insurance, accident and 
fidelity insurance, employers' liability insurance, and even 
life insurance. If a wife holds insurance on her husband's 
life, she avoids the evil, when widowed, of being left rela- 
tively destitute ; for the insurance provides her with an in- 
come which is a partial substitute for that formerly received 
from her husband. He and she prefer to sacrifice a yearly 
premium during his lifetime to avoid the risk of the sudden 



Sec. s] income FROM CAPITAL 429 

complete loss of income to her at his death. In short, the 
effect of pooling risks through insurance frees the individual 
of the large fluctuations in income which would otherwise 
be suffered. The income of society fluctuates less, rela- 
tively speaking, than that of the individuals composing 
society. This is true because the evils which form the 
extraordinary catastrophes in individual lives constitute a 
regular stream of events in the life of society. Death in a 
family is an unusual catastrophe, but the number of deaths 
in a community forms a regular and predictable series of 
events. To the owner of only a few vessels the shipwreck 
of one of them is an extraordinary catastrophe, but the ship- 
wrecks of the world constitute a regular and predictable 
series of events. The same is true of accidents and mis- 
chances of all kinds. They are irregular for the indi- 
vidual and regular for society. When, therefore, society 
through insurance companies and otherwise consolidates 
these risks, the individual gains an advantage by securing 
greater certainty and regularity in his individual income, 
even though the average income of the individual is not in- 
creased at all, in fact is decreased, by the cost of con- 
ducting the insurance companies. 

In this last connection it should be noted that insurance 
indirectly leads to the reduction of risk ; for insurance com- 
panies find it to their interest to reduce the risk against which 
they insure. Marine insurance companies expect the ships 
to secure the installation of safety devices. Fire insurance 
companies do likewise, and to-day even life insurance com- 
panies are beginning to advise their policy holders how to 
reduce the chances of death. 

In view of all that has been said, it is evident that insurance 
is one of the grandest of human devices in the warfare against 
risk. As its importance has gradually been appreciated, 
its use has been steadily extended, and in some cases, as 
in Germany, its employment (in certain cases affecting 
workingmen) has been made compulsory. 



43 O ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIII 

(4) It seems at first to be a curious fact that speculation, 
although dealing in chances, may be used to reduce chance to 
some persons who use it for this purpose. We have already 
seen how short selhng reduces the risk to the person sold to. 
A building contractor when taking a large contract was 
asked whether he was not taking a large risk, since he could 
not know in advance what the costs would be. He repKed, 
" No, I am taking no risks at all except on ' labor ' ; I have 
made contracts to be supplied with material when needed 
at fixed prices." In other words, dealers had sold him future 
building materials " short." They had each assumed the 
risk of fluctuation in those special materials in which they 
dealt, thus relieving the contractor of the necessity of in- 
forming himself of the special market conditions on stone, 
brick, timber, etc. Similar results follow from short sales 
of wool to the woolen manufacturer previously cited in 
another connection. 

An important method of shifting risks is " hedging," 
whereby a dealer, for instance in transporting wheat, may 
be relieved of the risk of a change in price. He buys wheat 
in the West intending to ship it to New York and sell it there 
at enough to cover cost of transportation and a small profit. 
He aims to make a gain in the form of " arbitrage," that 
is, a gain due to a difference in price between different 
places; but as the transportation requires time, he finds 
himself running the risk of a loss — or gain — due to a dif- 
ference in price between different times. By hedging he 
eliminates the time gain or loss and retains the place gain. 
If he did not " hedge," he might, in consequence of a sud- 
den fall in price, find all his profit wiped out ; or he might, 
on the other hand, by a rise in price, make much more than 
normal profits. Being of a cautious disposition, he prefers 
an intermediate course — a small profit which is sure, 
rather than the chances of both gain and loss. Conse- 
quently he " hedges " against loss. " Hedging " against a 
loss from the risks of one's business is speculation so ar- 



Sec. s] income FROM CAPITAL 43 1 

ranged that if the man loses in his regular business he will 
win in his speculation, or if he gains in his regular business 
he will lose in his speculation. It is like betting on both 
sides of a contest at the same time. The result elimi- 
nates largely the effect of risk so that he neither gains nor 
loses from mere chance. Thus let our supposed wheat 
dealer enter into some speculative market, such as Chicago, 
knowing that its prices will move in sympathy with the 
New York market, and there " speculate " for a fall, or 
sell " short." If the price of wheat happens to fall he will 
lose on the wheat which he has transported, but he will 
gain in his speculation. Evidently this man is running a 
double set of chances. A fall in price will bring him loss 
on the wheat he is transporting to New York; but, on 
the other hand, it will bring him gain in his specu- 
lation in Chicago. Contrariwise, if the price rises, he 
will gain on his wheat transported, but lose in the specu- 
lative market. He can draw his speculative contrast in 
such a way and for such an amount that for every cent 
per bushel of fall of price he will gain a cent per bushel 
in. his speculation, and for every cent per bushel of rise of 
price he will lose a cent per bushel in his speculation. In 
this way he will practically eliminate all loss as well as 
all profit arising from a change of price in time and keep 
intact the profit arising from a difference in price between 
places, i.e., he retains the arbitrage gains of his regular 
business and foregoes the speculative gains or losses, which 
are not his business. He only obtains his normal profit, 
commission, or percentage on the actual wheat handled, 
throwing the burden of risk of speculation on the specula- 
tive dealers to whom he sells short. 

Now it is evident that the effect of the short sales we have 
mentioned and of hedging is to shift the risk from those less 
able and willing to those more able and willing to bear it. 
Those grain merchants who hedge, for instance, are relieved 
of a big risk which they would suffer if they did not hedge. 



432 ELEMENTA-RY PRINCIPLES OF ECONOMICS [Chap. XXIII 

Thus, strange as it may seem, they run less risk by speculat- 
ing through " hedging " than by not speculating at all ; and 
as they thus reduce the risk of their business they are en- 
abled to reduce their margin of profit. Consequently, the 
public in the end receives a benefit in cheaper grain. The 
case is thus very similar to that of the builder and the woolen 
manufacturer. Short selling and hedging, binding the future 
and the past, enable the student of special risks to guar- 
antee the future to the general public. Risk is one of the 
direst economic evils, and all of the devices which aid in 
overcoming it — whether increased guarantees, safeguards, 
foresight, insurance, or legitimate speculation — represent 
a great boon to humanity. 

If risk could be completely eliminated, the profit of the 
stockholder would be more certain and steady and would 
average the same rate as the returns of those who receive 
explicit interest and rent. But, although there is a continual 
effort and tendency to reduce and consolidate risks, we can 
never expect in this world absolute certainty, and, as long as 
risks exist, there will be an important practical distinction 
between the income received in explicit interest and rent by 
such persons as the first two brothers and the profits and 
dividends received by those represented by the last two 
brothers. The former will always receive a certain and 
steady but small income, while the latter will receive a fluc- 
tuating but, on the average, a relatively large income. 



CHAPTER XXIV 

INCOME FROM LABOR 

§ I. Similarity of Rent and Wages 

We have seen that income always has a source, and that 
this source is either labor or capital, or, more usually, both 
jointly. We thus have two great agents in the production 
of income, labor and capital} The income from capital we 
have called " rent." The income from labor is called 

wages. '^ 

Corresponding to the distinction between explicit and 
implicit rent, we may distinguish between explicit and im- 
plicit wages, expHcit wages being wages actually paid to a 
hired person, called the employee, by the person hiring him, 
called the employer ; and implicit wages being the earnings 
of a person who does not sell his services, but enjoys them 
himself. Such a person we have already called an enter- 
priser.^ The earnings which the enterpriser secures ( so far 
as he secures them by working as an enterpriser) are called 
enterpriser's profits. 

^ As has been previously stated, " capital " is used in this book to in- 
clude land. Land is so important and peculiar a kind of capital that many 
writers prefer to make of it a special category and therefore to distinguish 
three agents of production — labor, land, and capital. It is also common 
to restrict the term " capital " still further by excluding goods in the hands 
of consumers or by other restrictions. The terminology here adopted is 
believed to be the most serviceable and also to conform more closely than 
most other textbook terminologies to the usage of business men. 

"^ The term " wages " is here used to include those forms dignified as 
" salaries." The usual distinction between wages and salaries is merely 
one of degree, and has no scientific significance. 

' Sometimes the French term " entrepreneur " is used. The English 
equivalent " undertaker," in the sense of one who undertakes an enter- 
prise, was formerly in vogue, but has fallen into disuse, perhaps because 
of its special application to funeral directors. 

2 F 433 



434 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

The income of a community may therefore be classified 
into rent and wages, and each of these subdivided into 
expKcit and impKcit classes. We thus have four great 
branches of income — explicit rent, explicit wages, implicit 
rent (or capitalists' profits), and implicit wages (or enter- 
prisers' profits). 

Moreover, since the income included under rent (explicit 
or impHcit) may be measured with reference to the value of 
the capital producing this income, it may also, as we have 
seen, be regarded as interest (explicit or implicit).^ 

Practically, therefore, we may divide the income of a 
community into six main parts simply by separating out from 
rent, whether explicit or implicit, the part which is reckoned 
in terms of the value of capital, i.e.^ that part which is in- 
terest, whether explicit or implicit. While it is true that all 
rent may be translated into interest, only part of rent is, in 
the actual world of business, so expressed. We therefore 
find in the modern world six great branches of income con- 
sidered in reference to the source from which it comes. 
These are commonly called wages and enterprisers' profits, 
rent and capitalists' profits, interest and dividends. The first 
pair are measured per man, the next pair per acre or other 
physical unit of capital, and the last pair as a percentage of 
capital-value. All six branches of income may be arranged 
as follows : ^ — 

^ In order to make a corresponding measurement of wages, i.e., wages 
relatively to the value of the men who earn them, we should need to ap- 
praise the value of free human beings. As this is both difl&cult and of 
little practical use, it will here be disregarded. 

^ The classification of income here given corresponds closely to that of 
business men, but differs somewhat from that in most other textbooks. 
A very common textbook classification of income divides it into rent, 
wages, interest, and profits. Of these four terms " wages " is generally em- 
ployed in the same sense as in this book. But the terms " rent " and 
" profit " are in many books employed in other senses. Thus the term 
" rent " is usually restricted by economists to income from land. It ex- 
cludes, for instance, the rent of houses. The term " profits " is used in 
many different senses, but is often restricted to enterprisers' profits. 

The student of economics needs to accustom himself to study carefully 



Sec. i] income from LABOR 435 

Explicit Implicit 

p, r 't 1 I Interest per cent f Profits per cent (dividends) 

^ LRent per acre I Profits per acre 

From Labor Wages per man Profits per man 

The principles governing the rate of wages are, in a gen- 
eral way, similar to those governing the rate of rent. The 
rate of a man's wages per unit of time is the product of the 
price per piece of the work he turns out multiplied by his 
rate of output in that time. His productivity depends on 
technical conditions, including especially his size, strength, 
skill, and cleverness, while the price per piece of his services 
depends upon the general principles of supply and demand 
as already set forth. 

The productivity of any capital, whether human or ex- 
ternal, will differ with the capital. Men differ in quality, 
i.e., in productive power, as truly as lands or other in- 
struments differ. Some men have a high degree of earning 
power and some have not. Some men can work twice as 
fast as others. Some men can do higher grades of work 
than others. The result is that we find men classified as 
common manual laborers, skilled manual laborers, common 
mental workers, superintending workers, and enterprisers. 
Just as we can measure the rent of any land by the differ- 
ence in productivity between that and the low-rent, or no- 
rent, land, in exactly the same way we can measure the 
difference in productivity between men. There is no grade 
of workmen called the " no-wages men," but there would 
be such a grade if it were customary for their employer to 
pay for their cost of support (as the employer of land pays 
for its cost), so that only the excess above this cost were 
to be called wages. There are, indeed, men so incompetent 
that their net earning power is nearly zero, and they can 

the terminology of each economic writer. Otherwise the conflict among 
these writers and the discrepancy between most of their concepts and the 
usage of business men may be found confusing. 



436 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

barely earn enough to support themselves. These incom- 
petents may be unfortunates, as in the case of invalids 
and imbeciles, or blameworthy, as in the case of indolents. 
But whatever the cause may be, they roughly correspond 
in economic analysis to no-rent land. 

§ 2. Peculiarities of Labor Supply 

But owing to the fundamental fact that a laborer, 
unlike any other instrument, is owned by himself and 
not, except in slavery, by another, there are certain 
peculiarities of wages as compared with rent. These 
peculiarities He in the supply curve. We shall note four 
of these peculiarities. 

In the first place, the supply curve of human services 
ascends very rapidly and often even " curls back," as pre- 
viously explained (Chapter XVII, § 3). This peculiarity, 
as we saw, was due to the fact that a man's desire for more 
money (marginal desirability of money) decreases rapidly 
with an increase of his earnings. Beyond a certain point 
the more he is paid, the less he will work. We may state 
the same fact in the reverse direction, and say that under 
certain circumstances the less a man is paid, the harder he 
will work. The shape of his supply curve will depend in 
very large measure on whether or not he has other sources 
of income besides his work. 

Figure 47 exhibits this fact. The curve SS'S" represents 
the supply curve of work for a well-to-do or rich man who 
has income from other sources than his work, and the curve 
5//' that for a poor man, who has to depend on what he 
can earn. The " rich " man represented in the diagram 
will not work at all for any wages below a certain price, 
say $1 an hour, or OS. Any price above this will induce 
him to work a little. Thus for $1.20 an hour he will work 
about two hours; for $1.40 an hour, about three and one 
half hours; and for $2 an hour, about five hours. But if 



Sec. 2] 



INCOME FROM LABOR 



437 



the price exceeds a certain height, S\ represented in the 
diagram as %2 an hour, the result will be that he will work 
less rather than more. These relations correspond with ob- 
served facts. A millionaire will not work for a day laborer's 
wages. He may work a few days in the year for $100 a day, 
and work more -y- 
days for $500 a 
day, but $1000 a 
day may lead him 
to work fewer days, 
and devote more 
time to vacations 
and to enjoying 
his large income. 

The poor man 
will be guided by 
similar considera- 
tions. His curve 
will be lower ver- 
tically, but wider 
horizontally — if 
the measure of 
work in each case 
is in hours of work 
person, he 




5 6 7 S 9 10 II 12 

hours 

Fig. 47. 



Owning little or nothing besides his 
cannot afford to be idle. Unemployment for 
him is seldom voluntary. So long as he can get a price 
for his work sufficient to keep him out of the poorhouse, 
he will work for that price. Thus, the minimum price 
which is necessary to induce him to work rather than be- 
come a tramp or beggar is represented in the diagram by 
Os, the very small sum of ten cents an hour. We note 
that it takes only a relatively slight rise in that price to 
induce him to work a full day. The height of / repre- 
sents the price at which he will work the greatest number 
of hours. Above this he will prefer slightly shorter hours. 
As already stated, it is probable that the eight-hour move- 



438 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

ment to-day is partly due to the fact that wages are high 
enough to enable the laborer to afford some leisure instead 
of being so low as to " keep his nose close to the grind- 
stone." 

A reduction in wages works in the opposite way, making 
workmen willing to work longer hours. Only when the price 
falls much below the elbow at / will they refuse longer to 
endure the low wages and long hours. They will then pre- 
fer, if not to starve, to throw themselves upon the mercy and 
charity of the community. The general level of the curve 
between the elbow, /, and the beginning, s, represents their 
minimum standard of living which they require if they work 
at all. 

Now, if wages keep high and the workmen have a suffi- 
ciently low degree of impatience for income to enable them 
to accumulate savings, they become more " independent," 
which, as applied to their supply curve j^V, means that 
it shifts a little toward the rich man's supply curve SS^S . 
The result is a higher minimum wage necessary to induce 
the laborer to work and a smaller maximum number of hours 
which he is willing to work. The intersection with the de- 
mand curve will therefore tend to be higher and may be 
farther to the left ; that is, the market rate of wages may 
be higher and the hours worked fewer. 

This result is not due to any reduction in the number of 
workmen, but simply to a reduction in their intensity of de- 
sire for money. Savings, therefore, making workmen more 
independent and less necessitous, will — by lessening their 
desire for money — both increase their wages and shorten 
their hours. 

A second pecuKarity in regard to wages is that, except 
under slavery, the earnings of a laborer are seldom dis- 
counted for the purpose of ascertaining his capital-value. 
The reason for making any appraisement usually has refer- 
ence to some proposed sale ; and, as working men and women 
are no longer for sale, their capital-value is seldom com- 



Sec. 2] INCOME FROM LABOR 439 

puted. For this reason, wages, unlike rent, are not often 
regarded in the hght of interest on the capital-value of the 
agents earning them. 

A third peculiarity of wages is one already alluded to, 
viz., that in practice they are always reckoned as gross and 
never as net. This is because the wages are reckoned from 
the standpoint of the employer who pays them, and not of 
the laborer who receives them. Under slavery the case was 
different, and the net income earned by a slave was com- 
puted in the same way as the net income earned by a horse 
— by deducting from the value of the work done the cost of 
supporting the slave. But under the system of free labor 
which now prevails, the employer has no such cost. The 
laborer assumes his own support, and furnishes only his 
work to the employer. The wages of the laborer are 
therefore reckoned gross. His net wages, if they are to be 
computed at all, are to be found by allowing for the irksome- 
ness of his work, i.e., the real costs which he bears of labor 
and trouble. At the margin — i.e., for the last unit of 
work done — this cost is, as we have seen, equal to the wages 
received for it ; but on all earlier units of work there is a 
gain of desirability which might conceivably be appraised in 
money. The net wages thus reckoned will be only a part 
of the wages as ordinarily quoted. 

When, therefore, we compare the $500 a year which a 
workman gets by selling his work with the $500 a year 
which a bondholder gets as interest, we must not forget 
that the workman's I500 is really less valuable than the 
bondholder's $500, and for two reasons. One is the reason 
just given, that the workman's $500 is obtained only by 
the sweat of his brow, while the bondholder's is all clear 
gain ; the other reason is that the workman's $500 will cease 
at his death or disablement, while the bondholder's goes on 
forever. 

A fourth peculiarity concerning wages is that the supply 
of wage earners differs from the supply of any other instru- 



440 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

ment. Except in slavery, workmen are not bred like cattle 
on commercial principles. A rise in the price of the serv- 
ices of a draft horse will increase the demand for draft 
horses, and the result will be that both the market price 
and the amount supplied at that price will be increased. 
Those who supply draft horses will breed them to take 
advantage of the higher prices of them and their services. 
A rise in the price of human services will not act so simply. 
It is true that a rise in wages usually increases the number 
of marriages and often increases the birth rate, but such is 
not always or necessarily the result ; and even when births 
do increase in number, they do not increase on the same 
commercial principles as the draft horses. It is an excep- 
tional father who can think or say as did a cynical old farmer 
who had raised a large family and thriftily turned their 
child labor to early account for his own benefit : " My 
children have been the best crop I ever raised." Ordinarily 
parents view their children not as potential earning power, 
but as objects of affection, and either do not attempt to 
regulate their numbers, or do so with reference to considera- 
tion for their own or their children's comfort. The prin- 
ciples which regulate the number of laborers are part of the 
principles regulating population in general, and will be con- 
sidered in the next chapter. 

§ 3. The Demand for Labor 

Turning now from the supply to the demand side of the 
market, we find that the demand of employers for the serv- 
ices of workmen is in general quite analogous to their de- 
mand for the services of land or of any other productive 
agent. Sentiment and humanity have a little influence, 
but not enough to require special attention on our part. 
Wages are paid by the ordinary employer as the equivalent 
of the discounted future benefits which the laborer's work 
will bring to him — -the employer — and the rate he is 



Sec. 3] INCOME FROM LABOR 44 1 

willing to pay is equal to the marginal desirability of the 
laborer's services measured in present money. We wish to 
emphasize the fact that the employer's valuation is (i) 
marginal, and (2) discounted. The employer pays for all 
his workmen's services on the basis of the services least de- 
sirable to him, just as the purchaser of coal buys it all on 
the basis of the ton least desirable to him ; he watches the 
" marginal " benefits he gets exactly as does the pur- 
chaser of coal. At a given rate of wages he " buys labor" 
up to the point where the last or marginal man's work 
is barely worth paying for. This marginal unit of work 
is a sort of barometer of wages. The employer's prob- 
lem in buying labor is the same as the householder's prob- 
lem in buying coal discussed in a previous chapter. He 
is constantly balancing in his mind the desirability of the 
work of his employees against the undesirability of the wages 
he pays for that work. If, say, he decides on one hundred 
men as the number he will employ, this is because the hun- 
dredth or marginal man he employs is believed to be barely 
worth his wages, while the man just beyond this margin, the 
one hundred and first man, is not taken on because the 
additional work he would do is believed to be not quite 
worth his wages. 

Secondly, wages which the employer pays are the dis- 
counted value of the future benefits he receives. Thus, the 
shepherd hired by the farmer to tend the sheep in the pas- 
ture renders benefits the value of which to the farmer is esti- 
mated in precisely the same way as the value of the benefits 
of the land which he hires, i.e., by discounting the value 
of the future yield of wool or other benefits toward the 
production of which the shepherd's work contributes. To 
take another example, suppose a landowner is contemplat- 
ing the planting of 10,000 trees which he believes will be 
worth as lumber in twenty years about $10,000, or one 
dollar per tree planted. His problem is : How much is it 
worth his while to pay per tree for the planting? The 



442 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

answer depends on the rate of interest. If this is three 
and a half per cent, it is worth his while to pay 50 cents 
per tree planted, for the present value ($1 discounted for 
twenty years at three and a half per cent) is $1 -i- (1.031)^", 
which is 50 cents (Chapter VI, § 4). As some trees may 
require more and some less labor, the landowner will Hmit 
his tree planting at that point or margin where the cost of 
the labor amounts to about 50 cents per tree. It follows 
that wages, like rent, are dependent upon the rate of 
interest. 

Every employer, in deciding whether his workmen are 
worthy of their hire, takes account of the probable future 
product and the time he must wait for it. If he under- 
takes to put up a sky scraper, he discounts the rent he ex- 
pects to get for it when finished. On that basis he decides 
whether or not he can afford to build it at current wages, 
and his decision will tend to affect those wages. The 
same is true of the manufacturer making cloth or the 
organizers of a railway construction company. In every 
case the employer of labor must discount the expected 
value of the product of labor. In fact an employer of 
labor has justly been called a " labor-broker," paying 
present cash for work which leads to future benefits. 

A rise in the rate of interest will tend to produce a fall in 
the rate of wages by lowering the discounted value of the 
final benefits from the work of laborers, and therefore lower- 
ing the prices which employers are willing to pay. Con- 
trariwise, a fall in interest produces a rise in wages. Thus 
if the rate of interest in the case of the landowner planting 
trees rises from three and a half per cent to six per cent, he 
can no longer afford to pay 50 cents per tree for the sake of 
getting back a dollar's worth of lumber in twenty years; 
for $1 discounted at six per cent for twenty years is worth 
only 31 cents. Consequently, the prospective landowner 
will diminish his demand for tree planters, and their wages 
will fall. 



Sec. 3] INCOME FROM LABOR 443 

In Chapter VI, § 5, we have seen that, the value of 
capital being the discounted value of future uses, a rise or 
fall in the rate of interest produces a fall or rise, respectively, 
in the value of capital, and that the more remote the future 
uses, the more pronounced is the effect of a change in the 
rate of interest. 

By this same reasoning, the dependence of wages on 
the rate of interest is the more pronounced, the more re- 
mote are the ultimate benefits to which the work of the 
laborer leads. In a community where the workmen are 
largely employed in enterprises requiring a long time, such 
as digging tunnels and constructing other great engineering 
works, the rate of wages will tend to fall appreciably with a 
rise in the rate of interest, and to rise appreciably with a fall 
in the rate of interest ; whereas in a country where the 
laborers are largely engaged in personal and domestic service 
or in other work which is not far distant from the final 
goal of enjoyable benefits, a change in the rate of interest 
will affect the rate of wages but slightly. 

Moreover, a change in interest will divert laborers from 
one employment to another. If interest rises, it will divert 
labor from enterprises which require much time and in which, 
therefore, the high interest is a serious consideration, and 
turn it into enterprises which yield more immediate bene- 
fits. For example, the higher the rate of interest, the less 
relatively will laborers be employed in planting slow-grow- 
ing trees, and the more relatively will they be employed as 
domestic servants, and vice versa. 

We have now considered the supply and demand of 
labor, or, to be exact, of the services of laborers. The 
rate of wages in each occupation will be such as will make 
the supply and demand equal, i.e., wUl "clear the market." 

One coroUary of the principle of clearing the market as 
applied to labor is that unemployment tends to correct 
itself. In the particular trades in which unemployment 
may, for a time, exist, the rate of wages will tend to fall. 



444 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

The fall in wages will call forth an increased demand for 
labor which will tend to absorb the unemployed. So long 
as any unemployment continues, wages will tend to fall 
until the demand for labor again equals the supply. It 
must, of course, be remembered, however, that in practice 
this equalization of supply and demand works itself out 
slowly and imperfectly. No market is a perfect market, 
least of all the labor market. For instance, the reluctance 
of a laborer to change his residence in order to get a new 
job, or his ignorance of the existence of jobs which he 
might have, impedes the free working of the machinery of 
supply and demand. 

What has been said applies only to wages under condi- 
tions of competition. Under competition they are deter- 
mined — like any other competitive price— by the familiar 
principles of supply and demand. If, instead of competition, 
we have conditions of more or less perfect monopoly, 
wages will be determined according to the principle of mo- 
nopoly price previously explained (Chapter XVII, § 9). If 
employers form combinations called trusts, or if laborers form 
combinations called trade-unions, there will be an effect on 
the rate of wages. These combinations tend to render 
bargaining collective instead of competitive, and the effects 
on the two sides of the market are worked out through 
struggles called strikes and lockouts. But the consideration 
of these subjects belongs to applied economics. 

§ 4. The Efficiency of Labor 

We have seen how the price of the laborer's services is 
determined. But the total income of a workingman will 
depend not only on the price he receives for each unit of 
work, but also on the number of units of work he turns 
out. His capacity to turn out work is called his efficiency. 
In general the greater the efficiency of workingmen, the 
greater will be the amount of real income they receive. 



Sec. 4] INCOME PROM LABOR 445 

This is perfectly obvious in the case of implicit wages, and 
every independent worker is so fully aware of it that he 
is constantly aiming to improve his own efficiency. The 
farmer, for instance, knows that the more work he can accom- 
plish in a day, the greater the income which he will enjoy. 
The more wheat he can gather this year with a given expen- 
diture of time and effort, the greater will be this year's in- 
come. He will, therefore, endeavor to gather as much 
wheat as possible with a given amount of effort, or, in other 
words, to put forth as little effort as possible to gather a 
certain amount of wheat. The more he can reap with a 
given amount of effort, the greater will be this year's income 
in relation to the cost or outgo ; and the more he can sow with 
a given amount of effort, the greater will be next year's in- 
come in relation to this year's outgo. His problem is always 
to minimize labor and to maximize the product of labor, 
and his prosperity depends upon his so doing. 

The same principle applies, in general, to wage earners, 
even when their wages are explicit, since the products of 
their labor will, to a great extent, be consumed by other 
laborers. While the interests of workmen lie chiefly in 
increased wages, these wages can only be obtained by ren- 
dering adequate services. Wages are not the gift of the 
employers, but the product of the workmen's own exertions. 
To attempt to get great wages without rendering great 
services in return is to fight the best interests of those 
other workmen who use the product. The more efficient 
the hired men on the farms in the West, the greater will be 
the wheat crop and the more abundant and therefore cheaper 
will be the bread bought by the employees in the shoe fac- 
tories in the East ; just as the more efficient the employees 
in the shoe factories in the East, the more abundant and 
cheaper will be shoes for the farm laborers in the West. 
It is, therefore, to the best interests of each workman that 
all other workmen should produce as much, and as eco- 
nomically, as possible. Moreover, while a workman may 



446 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

temporarily injure his employer by a policy of wastefulness, 
in the long run the employer will largely recoup himself for 
such wastefulness by charging higher prices for his products 
and thereby raising the general cost of living. Thus in the 
end the wasteful workman injures himself and his fellow- 
workmen. 

We have seen, then, that for the ultimate prosperity of 
all classes, including the laborers themselves, it is of the 
utmost importance that workingmen should do the largest 
possible amount of work in the most efficient manner in a 
given time. The efficiency of laborers can be increased in 
three chief ways: first, by improvement in physical and 
mental vitality ; second, by improvement in trade educa- 
tion; and third, by improvement in organization and 
division of labor. 

It is obvious that if a laborer performs his tasks under 
conditions which tend to impair his vitality, there will be a 
resulting injury to his prosperity and to that of the commu- 
nity of which he forms a part. The public is beginning to 
realize that there are many factors in a workingman's life 
which tend to lower his vitality and thus greatly to reduce 
his earning and producing powers. Some of these factors 
are due to his personal habits, some to the lack of proper 
public health regulations in the community in which he lives, 
and still others to certain conditions under which he works. 
Among the personal habits which are very harmful to the 
wage earner should be mentioned the use of alcoholic bev- 
erages. As employers are becoming more and more conscious 
of this fact, they are beginning to require temperance and 
sometimes total abstinence of their employees, particularly 
when those employees occupy positions which make them 
responsible for the safety of property and of lives. Sea cap- 
tains, locomotive engineers, and those charged with convey- 
ing telegraphic signals are often required to be total abstain- 
ers, and this requirement is being constantly extended to 
other classes of labor. Wrong habits of diet among work- 



Sec. 4] INCOME FROM LABOR 447 

ingmen are also often the cause of impaired vitality, and 
consequently of impaired efficiency. Some of these, such 
as the use of ill-balanced rations deficient in or containing an 
excessive amount of tissue-building elements, are the result 
of ignorance on the part of the workingman. Others, such 
as the use of injurious foods, like tuberculous meat, infected 
milk, or canned foods containing harmful preservatives, 
while due in part to the ignorance of the workingman, are 
more largely due to the failure on the part of the lawmak- 
ers of a community to enact and enforce laws which shall 
prevent the sale of such foods. 

There are many other ways in which lack of proper laws 
and regulations in a community endangers the health of the 
workingmen of that community. Among these is exposure 
to infection from those having infectious diseases, whether 
among neighbors, fellow-employees, or children in school. 
Housing conditions, especially as to ventilation, are partic- 
ularly objectionable and are at present the subject of much 
discussion and study on the part of social reformers. A 
recent investigation has shown that without increasing the 
expense to a community in the construction of houses for 
working people, it would be possible to secure for them 
sanitary conditions far superior to those which they now 
ordinarily enjoy. 

Still other causes of the impairment of the laborer's 
vitahty are certain conditions under which he works. The 
fight against excessively long working days, which is being 
carried on both by workingmen themselves and by others 
interested in their welfare, is gradually being won. Experi- 
ments in reducing the hours of labor from the present aver- 
age of about ten hours a day to nine hours, or in many cases 
eight, have often resulted in an increased productivity not 
only per hour, but per day. We are still suffering from the 
tradition handed down from the days of slavery when often 
the employer's whole effort was to " drive " his employees to 
the utmost. In many trades to-day an example of this 



448 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

'' driving " is seen in tiie " pace maker " or fast worker 
selected for his ability to work fast and employed to set 
a rapid pace for the other workmen. As laborers vary 
greatly in the rapidity with which they can turn out work 
this struggle to live up to an excessive speed standard, 
while it may result temporarily in an increased output per 
man per day, often results ultimately in producing chronic 
diseases and in injuring the health of the men in other 
ways to such an extent that their future earning capacity 
is greatly impaired. Trade-unions protest, and rightly, 
against the abuse of pace making ; but curiously enough, 
they strive to substitute another kind of inefHciency, the 
'' go easy " plan of purposely reducing output. They do 
not yet realize that workmen's prosperity depends on 
workmen's efficiency. 

We have seen how the efficiency of laborers can be in- 
creased by improvements in their physical vitahty. We 
shall next consider how it may be increased by improvements 
in trade education. When the apprentice system was prev- 
alent, a long technical training was required of workmen 
entering any trade. But modern division of labor has 
reduced the amount of education needed. When a laborer's 
work is so specialized that he only needs to make one or two 
motions — to turn a crank, or push a lever, or feed raw 
material into the hopper of some great machine — it is 
clear that no long course of training is necessary. A week's 
or a month's experience suffices to fit him for his particular 
little job. Consequently the apprentice system of prepara- 
tion for the complete mastery of a trade has fallen into 
disuse. Recently, however, a reaction has manifested 
itself and the need of trade education has been felt. With 
the advent of intricate machinery — of electrical apparatus 
in particular — there has grown a need of a great number of 
technically trained workmen. This need is being supphed 
by trade schools rather than by the old system of shop 
experience by apprenticeship. The discussion of trade 



Sec. 4] INCOME FROM LABOR 449 

schools does not belong in a textbook on the principles 
of economics, but they are mentioned as indicating one of 
the promising methods of improving workmen's efficiency 
and, therefore, improving their condition. 

It is true that a scarcity of trained workmen of any par- 
ticular sort, such as electricians' assistants, will tend to keep 
their particular wages high, and that a greater abundance 
of such workmen, as would result from trade schools, would 
reduce their wages. But it will improve the condition of 
the newcomers who otherwise would have been compelled 
to have remained unskilled and low-paid workmen, and, 
by withdrawing some of the number of unskilled workmen, 
it will tend to raise the wages even of the unskilled workman. 
It will improve the general average for all, because it will 
increase the total productivity of society. 

We come now to improvement in workingmen's efficiency 
through organization and division of labor. In the earlier 
and simpler stages of division of labor, an individual 
workman limited himself merely to a single trade. Thus 
one workman became a tailor, another a baker, a third a 
shoemaker, etc. The more constantly each practices at his 
particular trade, the greater becomes his dexterity in that 
trade. This obviously becomes much greater than that 
of a man who attempts to carry on several different 
occupations. "A jack at all trades is good at none." 
When labor becomes still more minutely subdivided 
so that the work of one individual becomes reduced to 
one movement or group of movements repeated over and 
over again, the workman not only becomes more skillful 
but the movement gradually becomes almost automatic. 
''Practice makes perfect." Shoemaking becomes a manu- 
facturing affair consisting of dozens of separate processes 
with special men to attend to each. One group cut 
leather, another drive pegs or sew, etc. Even these opera- 
tions are reduced to tending machinery which does most of 
the work. 

2G 



450 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

Besides dexterity from practice, another advantage re- 
sulting from division of labor is the adaptation of work to 
the qualities and abihties of the laborers. This is especially 
true in the case of mental workers. If a man who has ability 
for leadership turns over the less difficult and the mechanical 
parts to subordinates, devoting himself to the work which he 
alone can do or can do better than any one else, he becomes 
much more productive. 

Besides personal division of labor there is geographical 
division of labor. This, as indicated in Chapter II, §i, is 
partly because of special adaptation of certain climates 
and soils for the production of certain crops, partly because 
of the location of mineral deposits and water power, and 
partly because of the advantages of grouping estabHshments 
carrying on operations of a related kind. Thus Pittsburg is 
an iron and steel producing center largely because of its 
situation, being near deposits of iron and coal. 

The division of labor, both personal and geographical, 
means, of course, that the persons who perform the various 
operations of a certain branch of industry combine — 
whether consciously or unconsciously — to bring about the 
final result. The final product of modern industry is 
peculiarly a joint product of many hands and minds in 
many different parts of the world. 

While noting the advantages which result from division 
of labor, it is important that the student should realize an 
attendant disadvantage which should be understood and 
overcome, if possible, by trade education. This dis- 
advantage comes about through the fact that mere 
specialization, while it fits the laborer for his special 
task, does not qualify him to meet the requirements of 
a world where industrial conditions are rapidly changing. 
The fact that specialization prevents a workman from 
being able to change from one occupation to another lies 
at the basis of the complaints against labor-saving machin- 
ery. Probably the best results will be secured by com- 



Sec. s] income FROM LABOR 45 1 

bining special trade education and special trade experience 
on the one hand, and general education and general trade 
experience on the other. The more the laborer can have 
of a general grammar school or even high school educa- 
tion, the more adaptable he will be ; and if at any time he is 
thrown out of his special employment by changes, he will 
have less difficulty in adapting himself to the new employ- 
ment which this change almost inevitably brings about. 

The importance of general education for the workman 
is widely recognized, but it is not yet realized that a certain 
amount of general experience is likewise valuable. If em- 
ployers could see an advantage in changing the tasks among 
workmen from time to time, it is probable that the tempo- 
rary loss from such changes would more and more be offset 
by the greater intelligence and efficiency of the workmen 
which would result. 

The full discussion of the methods of increasing efficient 
production by workmen belongs to applied economics, and 
if the student wishes to follow these important and interest- 
ing subjects, he will find them in books on Labor Laws, the 
Housing Problem, Public Health, Hours of Labor, Child and 
Woman Labor, Technical Education, Factory Sanitation, 
Workmen's Compensation, Workmen's Insurance, etc. 

§ 5- The " Make-Work " Fallacy 

The blindness of workmen and others to the fact that the 
greater the efficiency of workingmen, the greater their own 
ultimate prosperity, is sometimes responsible for the " make- 
work " fallacy. According to this erroneous belief, the wel- 
fare of workmen depends, not on their productivity, but 
on their having jobs. On this basis they advocate great 
public works by the state in order to "make work" for the 
unemployed. According to this philosophy, a snowstorm 
blockading a city is an advantage to workmen, as it " makes 
work " for the snow shovelers. If we carry this logic a 



452 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

little farther, we should have to conclude that it would be 
an advantage to workingmen to destroy the houses of a 
community in order to make work for carpenters ; to break 
windows in-order to make work for glaziers; to burn up 
the stock of the clothier and the shoe dealer to make work 
for those employed in tailoring and shoe manufacturing; 
and in general to destroy all products of industry in order 
to make more work for those who produce. We could go 
even farther and advocate that without waiting for a snow- 
storm to blockade the streets, a city could benefit its 
workmen by engaging them to deliberately obstruct the 
street with dirt and then to shovel it away again, — thus 
" making work " not only in the removal, but also in 
the placing of the obstruction in the street. 

The make-work fallacy grows out of neglecting the goal 
at which work is aimed. Work is not pursued for its 
own sake, and has no justification except as it fulfills 
actual human wants. Mere aimless work cannot in the 
end benefit workmen. To produce things merely to be 
destroyed, or to shovel dirt back and forth with no useful 
object, will in the end reduce and not add to the real 
wages of workingmen ; for it reduces the volume of the 
products of labor which constitute the real wages. If shoes 
and clothes are destroyed, the main effect will be not to in- 
crease wages of shoemakers and clothiers, but to make 
workmen in general go ill-shod and ill-clothed. To break 
windows or to destroy houses will, as its main effect, not 
increase the wages of glaziers and carpenters, but decrease 
the quantity and the quality of shelter which workmen 
enjoy. No matter how complicated the organization of 
society, we cannot get rid of the simple fact that our welfare 
depends on our producing the largest possible output at the 
smallest possible cost, thus maximizing the final satisfactions 
of life and minimizing the effort by which they are obtained. 
The type of economic production may be pictured by Robin- 
son Crusoe picking berries. He will not try to " make work " 



Sec. s] income FROM LABOR 453 

for himself by destroying the berries he has picked ; he will 
not try to limit the amount of berries he picks ; he will enter- 
tain none of the other fallacies which in modern complicated 
conditions workmen so often do entertain. He will simply 
try to pick as many berries as he can with the least amount 
of effort and waste. Modern conditions of exchange and in- 
dustry do not modify this essential relation between satisfac- 
tions and efforts. They do, however, obscure the relation 
and as a result, lead to the make-work fallacy. This fallacy 
vitiates a great deal of the reasoning employed by trade- 
unions and by the uninstructed public. It is very analo- 
gous to the money fallacies which have been previously 
discussed, that confuse the mere medium of exchange with 
the goods exchanged thereby. It is almost as crude 
an error to suppose that workmen can be enriched by 
" making work " for them as that they can be enriched by 
issuing paper money. Work and money are merely means 
to an end. In order to rid ourselves of the money fallacy 
and the make-work fallacy, we must fix our attention on 
the end, and not on the means. 

One of many manifestations of the make-work fallacy is 
the prejudice of workmen against labor-saving machinery. 
They see themselves thrown out of work by the introduction 
of a labor-saving device. For instance, linotype typeset- 
ting machines threw out of employment many professional 
typesetters and rendered almost worthless their skill labori- 
ously acquired through years of practice. But it tended 
to increase the quantity and decrease the price of printed 
matter, including newspapers, and in this way to benefit 
workingmen in general. Another of the offsprings of 
the make- work fallacy is the policy of " protecting " a 
home industry against foreign competition. Thus the 
make-work fallacies, like the money fallacies, have been 
employed in aid of the protective fallacy. Whatever else 
of good may be said in favor of protection, the argument 
that it does good by making work for those employed in the 



454 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

protected industries is fallacious. The argument is quite 
analogous to the argument against labor-saving machinery. 
In fact, free trade may be thought of as a sort of labor- 
saving machinery, and the objections to free trade, which 
many instinctively feel, are quite analogous to the objec- 
tions which many workmen instinctively feel against labor- 
saving machinery. According to this argument we ought 
not to try to secure goods as cheaply as possible if by a 
greater expenditure of effort we can manufacture them at 
home ; for this home manufacturing will give employment 
to workmen. According to this argument, instead of im- 
porting woolen cloth from abroad, it is better to protect 
woolen manufacturers at home in order to " make work " 
for spinners, weavers, etc., in American woolen mills. Here 
again we come in contact with applied economics, and 
it is not within the scope of this book to discuss at length 
the pros and cons of protective tariff further than as it 
illustrates the make-work fallacy. 

The reasoning back of the make-work fallacy has been 
illustrated by supposing that a farmer driving his wagon 
to market should convince himself that to put sand in his 
axles would enable him to get to market faster. He might 
reason : " The harder the horse pulls, the faster the wagon 
will go ; if I put sand in the axles the horse will have to 
pull harder, and therefore will get me to market faster ! " 
To "make work" is to put sand in the axles of the in- 
dustrial wagon. It makes labor pull harder without 
getting on any faster. What we need is to grease the 
axles to reduce the effort required for a given result. 
Then with the same effort as before, or even less, we shall 
get a greater result. 

§ 6. Wages and Enterprisers' Profits 

What has been said applies to income received through 
wages in general, including both explicit and implicit wages, 



Sec. 6] INCOME PROM LABOR 455 

but implicit wages or enterprisers' profits need to be more 
particularly considered. Profits are in practice seldom called 
wages; for the term ''wages" is usually employed in the 
narrow sense of explicit or stipulated wages. 

The peculiarity of profits lies in the element of chance. 
Stipulated wages are supposedly certain, while profits are, 
by the nature of the case, uncertain. Many a worker has 
the option of hiring out to some one else or of being his 
own employer. In the former case he foregoes the chance 
of gain and the chance of loss. In the latter case he 
secures the chance of gain at the expense, however, of 
assuming a risk of loss. As a consequence, workmen 
classify themselves into two groups — wage earners 
or employees and enterprisers or employers — entirely 
analogous to the two groups into which we have seen that 
capitalists classify themselves; namely, bondholders and 
stockholders. And just as the bondholders consist of those 
who wish to avoid chance and the stockholders of those who 
are willing to assume risks, so also the employees are those 
who wish to avoid chance and the employers those who are 
willing to assume risks. And just as the stockholder stands 
sponsor to the bondholder for a stipulated income from capi- 
tal, so the employer stands sponsor to the employee for a 
stipulated part of the income from labor — or usually from 
labor and capital jointly considered. This is a consequence 
of the fact that those become enterprisers who believe them- 
selves to be especially adapted to the responsibilities which 
their position involves. 

The employee or recipient of explicit wages does not 
usually require foresight in any great degree, while one of 
the chief functions of the profit taker or enterpriser is to 
make forecasts. Again, a man, in order to be an employee, 
does not require any accumulation of capital, while an en- 
terpriser is far better equipped for his position if he is the 
fortunate possessor of a considerable fund of capital. It 
therefore happens that while theoretically an enterpriser 



456 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

may have little or no capital, practically he is usually a capi- 
taHst as well as an enterpriser. 

Profits stand in a double relation to (explicit) wages ; for 
the work of the enterprisers and the work of the wage earners 
are to some extent substitutes and to some extent mutually 
complementary. So far as the two kinds of work are sub- 
stitutes for each other, they compete, and the price of the one 
tends to correspond to the price of the other. If, for instance, 
wages of plumbers go down, it will often happen that a few 
enterprising plumbers, rather than take these low wages, 
will set up for themselves as independent plumbers and 
employ other plumbers at these low wages. The transfer 
of these men from the ranks of the employees to the 
ranks of the employers tends, by diminishing the supply 
of plumber employees, to raise their expHcit wages. On 
the other hand, by increasing the supply of plumber 
employers, it tends to diminish the implicit wages of the 
latter; in other words, to diminish the disparity brought 
about by the supposed fall in plumbers' (expHcit) wages. 

If, on the contrary, the wages of plumbers rise, it will 
often happen that the same or other men will move back 
from the ranks of employers to the ranks of employees. 
Finding that they can make only a small and precarious 
living as employers, either because there is too much com- 
petition among the independent plumbers or because of 
their own personal shortcomings or misfortunes, they now 
prefer to accept the high wages which plumbers are getting 
rather than to continue the fight any longer. 

There is a similar competition between the carpenter em- 
ployer and the carpenter employee ; in fact, between the 
" boss" and the ''man" in every trade or walk of hfe. If there 
were no difference in abilities, there would be a tendency for 
wages and profits to be almost equal, although there would 
usually be a slight difference in favor of profits owing to the 
fact that men in general regard uncertainty as an evil and 
require higher compensation for assuming it. Just as 



Sec. 6] INCOME FROM LABOR 457 

in general and normally a stockholder gets a higher aver- 
age return than the bondholder, so the profit taker will in 
general and on the average get a higher return than the wages 
guaranteed to the employee. 

But in actual life the difference in superiority of profits is 
still further increased by the fact that the enterprisers form 
a select class. While almost every enterpriser is capable of 
being a wage earner, not every wage earner is capable 
of being an enterpriser. Therefore the supply of enter- 
prisers is always somewhat restricted, and this fact tends 
to elevate their profits. Moreover, enterprisers are also 
a select class in that they are capitalists. While the 
possession of capital is not always an absolutely necessary 
qualification for becoming an enterpriser, it is so great an 
advantage as very materially to limit the number of those 
best equipped to be employers. While the possession of 
capital does not prevent a man from being a wage earner, 
the lack of it tends to prevent his becoming an employer. 
This still further limits the supply of employers and tends 
to elevate still further their profits. In short, the employers' 
or enterprisers' profits tend to be high for three reasons : 
(i) because these persons assume risks and responsibilities 
which few are able or willing to take ; (2) because for that 
very reason qualities of foresight, courage, and exceptional 
ability, which few possess, are required ; and (3) because the 
work of the enterpriser usually requires, for its success on 
a large scale, the possession of capital. 

Partly as a consequence of these peculiarities of enter- 
prisers and partly because of the general conditions of mod- 
ern industrial organization, the relation between employers 
and employees is not altogether or even generally competi- 
tive, but is to a large extent complementary. This comple- 
mentary relationship is more obvious and important than the 
competitive relationship just described. We may say that, in 
general, the employer and the employee in the same estab- 
lishment do not usually stand to each other in a competitive. 



458 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

but rather in a complementary, relation. The work of each 
is necessary for the efficient work of the other. The enter- 
priser could not accomplish very much if he worked merely 
by himself ; he requires for the best use of his abilities a large 
number of employees. Conversely, the employees cannot 
receive a guaranteed wage unless they find some employer 
who is willing to make the guarantee. The two stand in a 
relation similar to that existing between any two comple- 
mentary commodities, as, for instance, the relation of the 
engine to the train it draws. 

To the extent that enterprisers and wage earners are 
complementary, the earnings of the one tend to move not in 
unison with, but in opposition to, the earnings of the other. 
The lower the wages of the employee in any establishment, 
the more in general will be the profits of the employer, and 
vice versa. We see, therefore, that the relation between 
the employer and the employee is a complicated one, being 
partly competitive and partly complementary, and that 
therefore their interests, though partly allied, are largely 
opposed. The net result is usually that profits are far 
greater per capita than wages. 

But, while this is true of the average rate of profits, we 
must remember that, as the very nature of profits requires an 
element of chance, they vary enormously, and that in many 
instances the individual enterpriser may make less than the 
wage earner, or even less than nothing at all, while in other 
extreme cases he may make his fortune. 

§ 7. Profits and Distribution Generally 

Hitherto we have spoken separately of the capitalist who 
is a profit-taker and of the employer who is a profit-taker, 
but, as has been indicated, often one and the same person 
is both capitalist and enterpriser. In fact those who re- 
ceive profits as employers of labor usually receive profits 
also from capital which they own, although the converse 



Sec. 7] INCOME FROM LABOR 459 

is not so universally true. Those who wish to receive 
income through their capital without any work become 
bondholders rather than stockholders; while those who 
wish to get income from their work without investing 
(or perhaps even possessing) capital prefer to work for 
wages or salaries. If a man wishes to become a stock- 
holder, he usually is actively interested enough to do a 
certain amount of work, if it is no more than investigating 
the relative prospects of different companies offering chances 
for investors. And it is still truer that those who wish to 
take the responsibility of conducting an enterprise wish not 
only to put their effort into it, but their capital also. 

It thus usually happens that the profits which a man 
receives cannot be easily classified into profits from his 
capital and profits from his own exertions. Generally his 
profits are the joint product of both his labor and his capital. 
The profit-takers — who are, of course, also loss-takers — are, 
then, the risk-takers of society. Some men risk only their 
capital (and receive dividends per cent or profits per unit 
of physical capital according to the form of their invest- 
ment), others risk their own labor (and receive earnings 
of management), while most risk both their capital and 
their labor and receive the joint earnings of their capital 
and labor. These enterpriser-capitalists are well called 
the " captains of industry." They take the initiative in 
enterprises of all sorts, and on their judgment will depend 
whether not only their own capital and labor, but the 
capital and labor of others (to whom they undertake to 
pay stipulated interest or rent, on the one hand, and wages 
on the other), shal^ ^e economically or wastefully employed. 
When their leade: ihip proves wise they make large profits 
for themselves, but these may be said to be a well-deserved 
reward for the general good their sagacity brings the pub- 
lic. When their leadership proves unwise, they suffer a 
loss, and this may be said to be a deserved penalty for 
wasting the capital and labor of society. The men, like 



460 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

Commodore Vanderbilt, who have , built railways which 
were needed, have made fortunes. Those who have built 
railways which had to be abandoned have lost fortunes. 
There is, then, to some extent, a justification of our sys- 
tem by which we put a premium on enterprises which turn 
out well for society and a penalty on those which turn 
out ill. 

It is, however, also true that just as there are types of 
successful speculators which should be condemned, so there 
are types of successful enterprisers which should be con- 
demned. Those clever promoters who gain at the expense 
of the public through the frauds of " high finance " are 
among the worst forms of public enemies. 

The enterpriser-capitalist then is the leading figure in 
modern industry. He gathers round him other capitalists 
and laborers and jointly they produce the income of 
society. After paying them the parts of this income 
agreed upon, he takes for himself whatever may be left, 
large or small as the case may be. Their parts are the 
earnings of capital (in the two forms of rent and interest) 
and the earnings of labor (in the form of wages). His 
own part is the earnings of his own capital and labor (in 
the form of profits jointly on his capital — ^ whether meas- 
ured per cent or per unit of physical capital — and on his 
own labor). 

We cannot too much emphasize the fact that though 
each of the various laborers (both employers and employees) 
and instruments of capital (land and other instruments) 
which jointly produce income, is credited with a certain 
part, it could not produce this part alone, or by itself. The 
earnings of a railway company are due, for instance, to the 
joint services of the stockholders, bondholders, officers, em- 
ployees, locomotives, cars, roadbed, and terminals. These are 
not independent, but mutually complementary, instruments 
and laborers, and their services are complementary services. 
We impute to each a certain part, determined according to 



Sec. 7] INCOME FROM LABOR 46 1 

the principles which regulate the prices of complementary 
goods. 

The sum of all these items — that is, all the interest, rent, 
wages, and projSts, in any community in any given period 
of time is, of course, the total income of that community. 
An inventory of these would show what quota was contrib- 
uted to this total by or imputed to human beings, land, 
and other instruments. As a matter of fact by far the larger 
part is contributed by human beings. Professor Nicholson 
of Edinburgh has estimated that the income from what he 
calls "the Hving capital" of Great Britain is five times as 
great as that from the " dead capital." In less wealthy 
countries the preponderance of man-produced income is 
probably still larger. Of the part produced by " dead 
capital" the larger portion is from land. 

In a new country the rent of land is apt to be low, but rent 
of other things and wages high. For in such a country land 
is abundant, but other forms of capital, including laborers, 
relatively scarce. As a country grows older and more 
populous, land becomes scarce relatively to population, or, 
in other words, the demand for land increases without any 
increase in supply. Therefore land rent tends to rise, and 
other rents and wages to fall. 

Progress in scientific knowledge causing an increase in 
productivity of land is like the rejuvenation of a country. 
Any increase in general productivities, whether of land or of 
other agents of production, has a tendency to make the rate of 
wages increase. For (i) byincreasing the wealth of employers 
and thereby diminishing the marginal desirability of money, 
there is a tendency to increase their demand for everything, 
including the services of workmen ; and (2) so far as work- 
men themselves are owners of houses, implements, and other 
instruments of any kind, and thus share in the increased 
afiiuence, the supply of work they offer is decreased, as we 
have seen. 

Such a result is probably the chief general effect of so- 



462 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXIV 

called labor-saving machinery. It increases the income of 
other classes than laborers, and with it their power to buy 
work of laborers. The first effect, however, is for the labor- 
saving machine to displace laborers, with which, in fact, 
it is a competing article, and we have seen that the in- 
crease in one of two competing articles or substitutes tends to 
lower the price of the other. The individual laborers thus 
displaced are likely to be injured by the improvement, 
being unable to learn another trade without undue loss of 
time. It is even conceivable that labor-saving machinery 
might become so automatic and so fully a substitute for 
human work that there would be no need and no demand 
for such work. But such an effect seems very improbable. 
The human machine is so much more versatile than other 
machines that its relation as substitute for labor-saving 
machines is not so important as its complementary relation 
to them. As a matter of history, so-called labor-saving 
machinery, while it " saves " or displaces laborers from one 
sort of work, often, if not usually, produces new needs for 
them in another sort of work. If horses and carriages were 
introduced into China, they would largely dispense with the 
need of coolies, who now carry passengers in sedan chairs, 
but they would call for coachmen and grooms. When, in 
turn, stagecoaches give place to railways, the trade of drivers 
of stagecoaches becomes obsolete, but the new trades of 
locomotive engineers, firemen, conductors, and brakemen 
are created. In fact, the very names of these occupations, 
as of hundreds of others, show that the demand for these 
kinds of work arises from the existence of machinery. In 
other words, while labor-saving machinery is always, as 
its name implies, a competing article with the human 
machine with respect to some of the many-sided capacities 
of a human being, it is usually also a complementary article 
with respect to some other capacity; and we have seen 
that an increase in the quantity of one of two comple- 
mentary articles tends to increase the price of the other. 



Sec. 7] INCOME FROM LABOR 463 

In the present chapter as in the preceding, we have con- 
sidered income as distributed among the agents which pro- 
duce it, — labor and capital, including land. We are now 
ready to turn to the other sort of distribution, — the distri- 
bution among the owners. A decrease in the amount 
of capital which laborers own will, as we have already seen, 
make them willing to take lower wages than otherwise. 
In fact, the chief reason that there exists a wage class is 
that those constituting it have little or no capital apart 
from their own persons. Wage earners are chiefly " prop- 
er tyless " persons — persons who have either never had 
any property, or have lost what they did have, as, for 
instance, through too high a degree of impatience. We 
see, therefore, that the question of wages depends, among 
other things, on the distribution of the ownership of wealth. 
This will be the subject of the next chapter. 



CHAPTER XXV 

WEALTH AND POVERTY 

§ I. The Problems of Wealth and Poverty 

The first half of our study of distribution has been pre- 
sented in the two last chapters. It dealt with the dis- 
tribution of income relatively to the agents or instruments 
which produce that income. In the present chapter we 
shall take up the second half of the study — i.e., the dis- 
tribution of this same income relatively to those who own 
and enjoy it. The two sorts of distribution are quite dif- 
ferent, although there has been a tendency to confuse them. 
This was natural, for in the early days of economics people 
were classified roughly according to the sort of instruments 
they owned. There was the landlord class, whose chief 
income was ground rent ; the non-landed capitalist, whose 
chief income was from other capital than land; and the 
laborer, whose chief income was wages. It was then 
natural to imagine that the incomes produced by laborers, 
by land, and by other capital, were also the incomes en- 
joyed by laborers, by landlords, and by other capitalists. 
But even were such a classification possible and duly 
made, it would still fail to tell us anything whatever as to 
how large was the per capita share within each class, or 
whether the amounts enjoyed by different individuals 
were or were not very unequal. The best we could say 
would be that certain land yields a rent of $io an acre, 
and other lands more or less than this ; that certain houses 
rent for $1000 a year, and others for more or less ; that 

464 



Sec. i] wealth AND POVERTY 465 

money lenders make j&ve per cent on their loans ; and that 
ordinary wage earners get $2 a day. But these data, how- 
ever detailed, would not tell us the relative income enjoyed 
by different persons, except in the case of the common laborer, 
and then only on the assumption that he derived no income 
from any other source than from his work. Furthermore, 
to-day there are only small traces left of the old social strati- 
fication, and correspondingly little excuse for confusing the 
distribution of income with reference to the capital which, 
yields it and its distribution with reference to the persons 
who own it. 

But, though the two sorts of distribution are distinct, 
each is needed to understand the other. The problems now 
before us — of distribution relatively to owners — may be 
described as the problems of the total income of a nation, 
of the average income of its inhabitants, and of the rela- 
tive numbers of people owning incomes of various sizes. 

The last-named problem is the problem of grading the 
population according to income — the problem of discrim- 
inating the relatively rich and the relatively poor. No 
other problem in economics has so great a human interest 
as this, and yet scarcely any other problem has received so 
little scientific study. Since income necessarily comes from 
capital or from labor, the problem of "distribution" of 
income is largely that of the ''distribution" of capital. 
Our problem may therefore be stated in two ways : either 
as the problem of the personal distribution of income or as 
the problem of the personal distribution of capital and of 
labor-power. It is what is popularly known as the problem 
of " the distribution of wealth." 

For the purpose of comparing the incomes or capitals of 
different persons or nations, values are more important than 
quantities. If we know that A's income is worth $1000 a 
year and B's, $io,oob, we may say that B's income is ten 
times A's in the sense that the elements composing B's 
income are worth in exchange ten times the elements com- 



466 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

posing A's income ; or, if we know that X is " worth " 
(i.e., owns capital worth) $1,000,000 and that Y is " worth " 
$10,000,000, we may say in like sense that Y's capital is 
tenfold X's. 

In order to compare the incomes or capitals of widely 
distant times or places, a correction may need to be made 
for differences in the purchasing power of money, and if the 
rate of interest is also different in the two cases, the result 
of the comparison will not necessarily be the same for the 
capital as for the income. A millionaire worth $1,000,000 
in California half a century ago, the rate of interest being 
twelve per cent, commanded an income equivalent to that 
of a multimillionaire to-day, worth $3,000,000 ; for the pres- 
ent rate of interest is only one third as high. If, therefore, 
we were to compare the possessor at that time of $1,000,000, 
having an income of $120,000, with the possessor now 
of $2,000,000 having an income of $80,000, we should 
have to say that though the first was only half as rich in 
capital as the second he was fifty per cent richer in income. 
Another point of difference between comparisons of capital- 
value and comparisons of income-value lies in the fact that 
while capital- values differ only in size, income- values differ 
also in distribution in time as well as in certainty. For 
this reason a man rich in lands from which there happens 
to be little immediate income — but only prospects of 
income in the distant future — is sometimes called " land 
poor," having much land, but little immediate income. 

But when we are seeking to compare the absolute com- 
forts which different persons or nations enjoy, it is more 
important to consider quantities than values. In fact, as 
noted at the outset of our study, money valuations are 
apt to be misleading. A country where water is scarce 
will put a higher money valuation on its water supply than 
a country where water is so abundant as to have no price. 
Thus, a large quantity of water shows more affluence in the 
sense of " desirabihty " than does a large value of water. 



Sec. 2] WEALTH AND POVERTY 467 

Practically, however, if we confine our attention to 
modern times and conditions in western Europe and 
America, it is true, in a general way, that of two nations or 
individuals the one which is richer in capital-goods is richer 
also in income-goods, in income-value, and in capital-value. 
For simplicity we shall hereafter assume that these four 
comparisons are thus similar. We may say that a man is 
*' rich " if he has a large amount of capital-goods of various 
kinds — lands, houses, stocks, bonds, etc. ; or a large 
money- value of such goods ; or a large amount of benefits 
of various kinds — nourishment, clothing, shelter, amuse- 
ments, etc. ; or a large money-value of such benefits. A 
man is "poor" if he has small amounts of ah these things. 

Of course, the two terms " rich " and " poor" are purely 
relative, and represent no deeper scientific meaning. A man 
who is rich according to one standard may be poor accord- 
ing to another. But the two terms are very convenient to 
designate relative conditions. Corresponding to the ad- 
jectives " rich " and " poor " are the nouns " wealth " 
and " poverty " ; for, as noted in the first chapter, the term 
" wealth " is especially used to indicate a large amount of 
wealth, just as the term " poverty " is used to indicate 
a small amount. Our subject, then, in this chapter is 
comparative wealth and poverty, both of nations and of 
individuals. 

§ 2. National Wealth or Poverty 

We may divide this subject into two heads : the 
wealth or poverty of nations and the wealth or poverty 
of individuals. We shall first consider the wealth or pov- 
erty of nations. 

" The wealth of nations " depends upon two things : 
their labor and their capital, including their lands and 
the other capital the people have produced. The income 
earned by the people of a nation always far exceeds the 



468 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

income earned by all its capital. Yet people do not earn 
income without at least land. Given laborers and land, 
we have the only two real requisites of producing income. 
Other capital springs from these two. It is sometimes said 
that labor is the father, land the mother, and the other kinds 
of capital the children. A nation, then, is the richer, the 
larger the number of its inhabitants, the greater the extent 
of its territory, and the greater the amount of its accumu- 
lated products. 

These three factors depend each on somewhat different 
conditions. The amount of land and its power to pro- 
duce is largely a question of natural resources. It may 
be taken as a given quantity presented to man by nature. 
It is now becoming recognized, however, that land is not 
so definitely constant in its power to produce as was once 
imagined. One of the most important results of the recent 
"conservation movement" in this country has been to show 
conclusively that land is not altogether a constant source 
of income, but that it is possible by the impoverishing and 
washing away of top soil greatly to impair or destroy ab- 
solutely the productivity of land ; while, on the contrary, 
by proper fertilization, keeping land fallow, rotation of 
crops, etc., it is possible to increase the efficiency of land 
just as it is possible to increase the efficiency of other 
instruments. 

The dominion over land by any given group of men 
may depend on wresting it by military force from another 
group. In fact, one of the chief objects of war has been to 
increase national wealth by adding to territory. This was 
a chief object of the Roman Empire and of the colonial 
system of Great Britain. These and other nations have 
had what is called " earth hunger." The wealth of the 
British Empire to-day lies for the most part outside of the 
British Isles ; for it includes, besides England, a number of 
important colonies — Canada, India, Australia, and parts 
of Africa. Except for the war of the Revolution, the 



Sec. 3] WEALTH AND POVERTY 469 

British Empire would now include also the territory occu- 
pied by the United States. 

Turning from the quantity of land or the "natural 
resources " of a nation to the number of inhabitants, 
we note that this itself depends in turn upon the extent 
of the territory as also on the past history of the nation 
and on other conditions which will be considered later 
in this chapter. Many nations have sought to increase 
their wealth and power by increasing their population. 
In fact, a chief reason for extending a nation's ter- 
ritory has been to fill it with colonists. A country is 
usually alarmed at the prospect of a stationary or decreas- 
ing population. France is now trying to conserve its 
population, recognizing that national strength for future 
war or for future political position among the nations of 
the earth depends largely on the number of fighters and 
of workers. The productiveness of these people, as well as 
the productiveness of the lands they keep, will depend 
largely upon their condition as to vitality and accumulated 
knowledge. 

We come last to the amount of accumulated products. 
This depends on two chief quaUties : first, thrift, which, as 
we have seen, leads to savings ; and, secondly, inventive- 
ness, which has led to the creation of income-producing 
instruments. 

§ 3. Per Capita Wealth or Poverty 

We have considered the conditions determining the ag- 
gregate wealth of nations. We may pass now to the more 
important subject of the wealth or poverty of individuals. 
This subject may be divided into two parts : the study 
of average or per capita wealth, and the study of its dis- 
tribution or the relative wealth and poverty among differ- 
ent individuals. By the per capita wealth of any nation 
is meant the quotient found by dividing the total national 



470 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

wealth by the number of inhabitants. It is evident that 
two nations may compare very differently as to aggregate 
and as to per capita wealth. The small countries, Holland 
and Switzerland, when compared with the large countries, 
India and China, are far poorer in aggregate wealth, but 
far richer in per capita wealth. The per capita wealth 
in any nation will thus increase with an increase in the 
total wealth (the population remaining the same) and de- 
crease with an increase in population (the total wealth 
remaining the same). 

With the advent of democracy in poHtics has come a 
greater emphasis on per capita as compared with aggregate 
wealth. Under autocracies the aim was to increase the 
wealth of the nation as a whole, partly for the mere 
aggrandizement of the autocrat or potentate, who often re- 
garded himself as a sort of owner of the nation {" Vetat, 
c'est moi "), and partly because the popular sentiment of 
national greatness was satisfied in this way. Under these 
conditions an increase in population was almost invariably 
welcomed and encouraged. But since the individuals of the 
nation have become its rulers and, so to speak, shareholders, 
they have regarded increase of numbers with mixed feelings ; 
for while on the one hand they welcome an increase in 
the total wealth which a greater population brings, on the 
other hand they do not relish a decrease in the per capita 
wealth which may ensue. In the democratic ideal, there- 
fore, an increase of population is usually welcomed only in a 
new country where there is plenty of land, or in a country 
acquiring colonies to provide room for a surplus population. 

The effect of an increase of national wealth on per capita 
wealth will evidently depend upon the ratio between land 
and population. In a sparsely settled country an increase 
of population will not only increase the aggregate, but also 
the per capita wealth ; for each new worker adds, by his 
cooperation, to the efi&ciency of workers already on the 
ground. A very few men cannot work together to as great 



Sec. 3] WEALTH AND POVERTY 47 1 

advantage as a moderate number. The cooperation and 
division of labor incident to a moderate increase in popu- 
lation more than outweigh the fact that the greater popu- 
lation will require more nourishment, clothing, and other 
items of income. In short, though there be more mouths 
to feed, each additional mouth means an additional pair 
of hands ; and the added capacity of the new hands to 
produce exceeds the added capacity of the new mouths to 
consume. The history of new countries shows that an in- 
crease in population is a blessing individually and col- 
lectively. 

When, however, the country is settled and filled up with 
population to a certain point, the opposite becomes true, 
and a fresh increase of population, while continuing to in- 
crease aggregate wealth, will decrease per capita wealth. 
It then happens that each new pair of hands adds less to 
production than each new mouth subtracts in consump- 
tion. This fact sets a sort of elastic limit to an increase of 
population. That there must be such a limit is evident, 
since an indefinite number of people cannot be supported 
on one acre of land. We know as a generalization from 
ordinary observation that the billion and a half people 
now living on this planet could not be supported if all were 
packed into the state of Rhode Island and dependent on 
Rhode Island for sustenance. Per capita poverty would 
then be so intense that people would die of actual starva- 
tion. Famine, with the plagues which usually follow it, 
would decimate the population. Overpopulation in India 
and China often results in famine and plague. But in 
western civilization much milder instances of insufificiency 
of food are found. Long before such a starvation point is 
reached, every increase of population beyond a certain point 
results in an increased death rate. In fact, statistics show 
that the death rate increases as per capita wealth decreases. 
This fact is due to the unsanitary conditions which poverty 
necessarily brings — conditions which pertain not so much 



472 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

to the quantity of food as to its quality and to the quantity 
and quality of housing and other comforts and conveniences 
of life, and perhaps above all to conditions of employ- 
ment, especially hours of labor. These unsanitary condi- 
tions incident to poverty result in fatigue, malnutrition, in- 
fection, diseases such as tuberculosis, and deaths. We have, 
then, ample evidence that when the ratio of population to 
land becomes excessive, the death rate is increased, and 
consequently the further increase of population is checked. 
This law of per capita wealth is chiefly based on the 
anterior fact that land is an essential agent in production, 
and that each successive increase in the productivity of 
land is acquired at increasingly great cost — or, expressed 
otherwise, that, with each successive increase in cost, the 
return diminishes. This is the famihar law of diminishing 
returns in agriculture. There is, then, based on facts, a 
general law of per capita wealth in relation to population. 
It may be stated as follows : Given' a particular stage of 
knowledge and of the arts and of other conditions that 
determine productivity, an increase of population up to 
a certain point increases the per capita wealth, after which 
a further increase of population decreases the per capita 
wealth. 

§ 4. Population in Relation to Wealth 

The population of any country may be increased either 
by births or immigration and decreased either by deaths or 
emigration. The population of the world, as a whole, can be 
increased only by births and decreased by deaths. As we 
are more interested in general than in local increases or 
decreases in population, we may overlook the questions of 
emigration and immigration, assuming for the area under 
consideration that they are either absent or balance each 
other. 

With this proviso, we may say that population will 



Sec. 4] WEALTH AND POVERTY 473 

decrease if the death rate exceeds the birth rate, and 
will increase if the birth rate exceeds the death rate. As 
we have already stated, the facts show that the death 
rate increases with a decrease in per capita wealth. The 
birth rate, on the other hand, tends to decrease with a 
decrease in per capita wealth. There are exceptions to 
this last statement, but these exceptions will be ignored 
for the present. 

If we assume what -history has almost invariably shown 
to be the fact, that in a sparsely settled country the birth 
rate exceeds the death rate, so that the population tends at 
first to increase, we are now in a position to state what will 
happen to the population of that country in future genera- 
tions, quite apart from any increase in immigration. By 
hypothesis the population will increase at first and, as at 
first each increase in population brings an increase in per 
capita wealth, it will continue to increase as long as this 
condition continues. But, as we have seen, it will ultimately 
happen that per capita wealth will cease to increase and will 
begin to diminish. It will then happen that the death 
rate will increase and the birth rate decrease, so that the 
increase of population will be slackened and ultimately 
cease altogether. Under these conditions, then, population 
in a new country will increase up to a certain point at which 
it will cease to increase. The population is then in a sort of 
equilibrium, the birth rate equaling the death rate because 
the per capita wealth has been reduced to such a point as 
to bring this equilibrium about. 

The laws of population, therefore, may be stated as fol- 
lows: 

1. An increase in population will tend to increase ag- 
gregate wealth but less rapidly than population. That is, 
the increase in population tends to decrease per capita 
wealth. 

2. A decrease in per capita wealth will tend to increase 
the death rate and decrease the birth rate. That is, the 



474 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

decrease in per capita wealth checks the increase of popu- 
lation. 

In accordance with these laws the sequence of events 
is usually as follows : In a new and sparsely settled coun- 
try, population at first increases. As the country fills up 
this increase is slackened and finally comes to a standstill 
when the death rate equals the birth rate. This station- 
ary state is reached when the people are either unable or 
unwilling to lower the standard of subsistence. Such a 
stationary state has been nearly reached in India, where 
people are unable to lower the standard of subsistence, and 
in France, where they are unwilling. In most countries, 
population is still increasing and will probably continue to 
do so until the vast areas opened up by exploration and 
colonization in the last four centuries shall have been filled 
up. These areas include North and South America, 
Australia, and parts of Africa. The rendering available 
of these continents to occupation by Europeans constitutes 
the greatest economic event of modern times and has 
relieved for a season the pressure of population on sub- 
sistence. Similar relief has been afforded by great labor- 
saving inventions which enable a given population to 
secure increased subsistence. Future inventions may be 
expected to increase this process. But ultimately there 
must be a limit to the capacity of the world to support 
population. 

This limit on human population is the same sort of limit 
which nature sets on animal and plant population. Blades 
of grass multiply until they cover the ground on which they 
grow. When grass is sown on a grass plot, it multiplies 
with great rapidity, but after the whole plot is covered and 
there is no room for more, the number of blades remains 
nearly stationary. There is a struggle for Hfe constantly 
going on, and the death rate thus produced is great enough 
to balance the birth rate which the capacity of the soil 
allows. Out of this struggle for existence among animals 



Sec. 4] WEALTH AND POVERTY 475 

and plants comes what Darwin called natural "selection," 
and it is interesting to know that Darwin's first idea of such 
a struggle came from reading the economist Malthus, who 
first wrote an important treatise on Population. Popula- 
tion may then be said to be hmited by the means of sub- 
sistence. 

Since Malthus's day there has come into more definite 
operation what he called the " preventive check " on popu- 
lation. While it is still true that among the poor it usually 
happens that an increase in per capita wealth tends to 
increase the birth rate by encouraging marriages or making 
them earlier or increasing the number of children per mar- 
riage, it has become unfortunately true that among the 
wealthier classes an increase in wealth tends sometimes in 
the opposite direction. Instead of wealth being then 
thought of as a means of supporting children, it comes 
to be thought of as a means for gaining or maintaining 
" social position," and the more wealth gained, the more 
ambitious are its possessors that its enjoyment may not be 
interfered with by childbearing, or that it shall not be de- 
creased by subdivision in the next generation. The result 
is that the wealthier classes often have, on the average, 
smaller families than the poorer classes. We must, there- 
fore, modify the law of population so as to read that an 
increase in per capita wealth, instead of tending always to 
increase the birth rate, tends first to increase it and then, 
after the increase of wealth passes a certain point, to 
decrease it. This wealth check to population is peculiar. 
It is quite different from the poverty check. The poverty 
check works automatically so as to check population when 
it is too large and not to check it when it is too small. But 
the wealth check acts in the opposite way — or rather it 
would do so if it were sufficiently strong and general, which 
is not yet the case. Then it would come about that the 
greater the per capita wealth, the more would population 
be checked, and as the check to population usually tends 



476 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

to increase per capita wealth, this would still further de- 
crease population. The logical result is depopulation or 
" race suicide." 

At present, however, this wealth check is confined to cer- 
tain parts of the population, and results, for those parts 
only, in " race suicide." These parts include particularly 
the so-called " better classes " of the population. Statis- 
tics show that the children of college graduates are less 
numerous than the graduates themselves. Thus, besides 
depopulation, there is another danger, degeneration. If 
the vitality or vital capital is impaired by a breeding of 
the worst and a cessation of the breeding of the best, no 
greater calamity could be imagined. But while the risk of 
such a result undoubtedly exists, this is not immediate, and 
an increasing realization of its possibility, we may hope, 
will lead to some way of counteracting it. A method of 
attaining the contrary result — namely, reproducing from 
the best and suppressing reproduction from the worst — 
has been suggested by the late Sir Francis Galton of Eng- 
land, under the name of " eugenics." This movement, 
which promises to become a strong one, aims to prevent 
(by isolation in public institutions and in some cases by 
surgical operations) the possibility of the propagation of 
feeble-minded and certain other classes of defectives and 
degenerates, and also to develop a public sentiment which 
shall condemn marriages in which either husband or wife 
has a transmissible disease, or any inheritable taint of 
epilepsy, insanity, etc., or is otherwise unfit to become a 
parent. 

§ 5. Distribution of Wealth 

Having considered aggregate and per capita wealth, we 
come finally to the distribution of wealth among different 
individuals. Although a whole nation may be rich or poor 
relatively to another nation, the widest differences between 



Sec. 5] WEALTH AND POVERTY 477 

nations are small as compared with the differences within 
any one nation. Every nation has its extremely poor, its 
extremely rich, and its classes in intermediate conditions. In 
the United States there are many wage earners who can- 
not earn $1 a day, and who have no income except what they 
earn by labor, while at the opposite extreme are the multi- 
millionaires who receive incomes of over $1,000,000 a month. 

What are the reasons for such prodigious inequahties in 
the personal distribution of wealth? Are such inequaHties 
injurious? If so, are they preventable? If so, by what 
means? These are some of the most burning questions of 
the day. Out of them spring many reform movements, 
and especially socialism. But these, like other practical 
problems, are applications of economic principles, and 
cannot be discussed in a book designed to treat only of 
economic principles themselves. Sufhce it to say that no 
proper answer can be made to the last question — how to 
cure the unequal distribution of wealth — until we have 
answered the first question — what causes this unequal dis- 
tribution. As often happens, more study has already 
been devoted to cure than to diagnosis, and with the usual 
ineffective result of quack remedies. 

Our present object will be to set forth the causes which 
affect the relative personal distribution of wealth. What- 
ever these causes may be, they are evidently fundamental 
and universal; for we find that extremes of poverty and 
riches have existed at all times and places. They are men- 
tioned in the Bible and other histories of peoples in all ages 
and stages of civilization. It is probable that the degree 
of inequaHty differs as between the Oriental civilizations, 
like China and India, on the one hand, and the Occidental, 
like England and France, on the other, and also as between 
the older settlements of western civiHzation, like Russia and 
Italy, and the newer, Uke the United States and Canada. 
But the fact of inequality and also its causes are nearly the 
same everywhere. Distribution differs in some degree, it is 



478 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

true, according to political institutions, as, for instance, 
between Germany and England. There is a comparative 
absence of extreme poverty in Germany as contrasted with 
England and the United States ; a comparative prevalence of 
poverty in Russia and Italy ; and a comparative frequency 
of extreme opulence in Holland. Nevertheless, Professor 
Pareto, a Swiss economist, has found that, as between dif- 
ferent countries for which statistics are available, and as 
between various periods of time, the statistics of inequal- 
ity in the distribution of wealth show a remarkable cor- 
respondence, more close, in fact, than that shown by the 
statistics of mortality. 

The causes which have produced the present inequalities 
of wealth are largely historical ; that is, they lie in the 
past. It usually takes more than one generation to affect 
greatly the economic standing of a family. For this reason 
some people have foolishly imagined that if to-day we could 
once correct the inequalities in wealth handed down to us 
from the past, the problem would be solved, and with a 
new and even start we would be forever rid of great poverty 
by the side of great wealth. We shall soon see, however, 
that if wealth were once equally divided, it would not re- 
main so. The analysis of what would happen will serve 
as the best introduction to our study of distribution. 

§ 6. Equality of Distribution an Unstable Condition 

Let us suppose that, through some communistic or social- 
istic law, the wealth in the United States were divided with 
substantial equaUty. It is proposed to show that this 
equality could not long endure. Differences in thrift alone 
would reestablish inequahty. We cannot suppose that 
human nature could be so changed and become so uniform 
that society would not still be divided into " spenders " and 
" savers" ; much less can we suppose that different people 
would all spend or all save in exactly the same degree. So 



Sec. 6] WEALTH AND POVERTY 479 

long as there are any differences whatever between people 
in regard to their degrees of impatience under like condi- 
tions, they will be led by these differing degrees of im- 
patience to exchange present and future incomes among 
themselves. As a consequence there will ensue differences 
in spending and saving, and therefore differences in capital. 

The larger the amounts saved or spent, the more rapidly 
is capital gained or lost. As we have seen, the process 
by which individuals thus gain or lose fortunes by saving 
or spending consists, in the last analysis, of an exchange 
of present and future income. If two men have to start 
with the same income of $1000 a year, but one has a rate 
of impatience above the market rate of interest and the 
other has a rate below, the first will continue to get rid of 
future income for the sake of its equivalent in immediate 
income, and the other to do exactly the opposite. Such 
substitutions of immediate for remote, and of remote for 
immediate income may take place by means of loans, sales, 
or changed uses of capital. The man with spendthrift tend- 
encies will borrow, i.e., pledge future income for the sake of 
present income ; or he will sell any durable goods which 
offer remote income, such as farms or forests, and buy 
perishable goods which offer immediate income,' such as 
champagne, clothing, horses, and carriages ; or he will change 
the uses to which he puts his capital, avoiding those which 
require improvements, and choosing instead those on which 
he can realize quickly, thus letting his property run down. 

The man with saving tendencies, on the other hand, will 
lend or invest present income for the sake of future, will 
sell perishable and buy durable goods, and will make far- 
sighted uses of his capital. He will invest in stocks and 
bonds and in real estate capable of large future income. 
Both men will pursue their respective policies up to the 
point where their marginal rates of impatience harmonize 
with the rate of interest. 

These effects on capital are worked out by the prin- 



480 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

ciples of Chapter VII. If a modification of the income- 
stream is such as to make the present rate of reahzed income 
exceed the "standard" rate, capital is being depleted to 
the extent of the excess, and the person will grow poorer. 
Individuals of the type of Rip Van Winkle, if in possession 
of land and other durable instruments, will sell or mortgage 
them in order to secure the means for obtaining enjoyable 
services more rapidly. The effect will be, for society as a 
whole, that these individuals who have an abnormally low 
appreciation of the future and its needs will gradually part 
with the more durable instruments, and that these will 
tend to gravitate into the hands of those who have the 
opposite trait. 

It requires only a very small degree of saving or spend- 
ing to lead to comparative wealth or poverty, even in one 
generation. It is remarkable how much may be saved in 
a lifetime by thrift. Cases are sometimes found of day 
laborers who, by saving and putting at interest, accumu- 
late within a lifetime a small fortune, and in the mean- 
time rear a family. As Micawber said, a man with an 
income of one pound a week will reach ultimately poverty 
if he spends just one penny more, and reach opulence if he 
spends just one penny less. 

A central role in the distribution of wealth is thus played 
by the degrees of preference for present over future income 
and the rate of interest. The existence of a general market 
rate of interest to which each man adjusts his rate of pref- 
erence supplies an easy highway for the change in his cap- 
ital in one direction or the other. If an individual has 
spendthrift tendencies, their indulgence is facihtated by 
access to a loan market; and reversely, if he desires to 
save, he may do so the more easily if there is a market 
for sa\dngs. The irregularities in the distribution of capi- 
tal are thus due in part to the opportunity to effect ex- 
changes in the present and future parts of the income- 
streams of different people. The rate of interest is simply 



Sec. 6] WEALTH AND POVERTY 481 

the market price for such exchanges. By means of this 
market price, both those who wish to barter present for 
future income and those who wish to do the reverse may 
satisfy their desires. The former will gradually increase, 
and the latter gradually diminish, their capital. If all in- 
dividuals were hermits, it would be much more difficult 
either to accumulate or to dissipate fortunes, and the dis- 
tribution of wealth would therefore be much more even. 
InequaHty arises largely from the exchange of income, car- 
rying some individuals toward wealth and others toward 
poverty. In short, the inequaUty of wealth is facihtated 
by the existence of a loan market. In a sense, then, it is 
true, as the socialist maintains, that inequality is due to 
social arrangements; but the arrangements to which it is 
due are not, as he assumes, primarily such as take away 
the opportunity to rise in the economic scale. On the con- 
trary, they are arrangements which facilitate both rising 
and falling, according to the choice of the individual. The 
improvident sink like lead to the bottom, while the provi- 
dent rise to the top. 

But thrift, important as it is, is not the only road to 
wealth, nor thriftlessness the only road to poverty. Besides 
differences in the rates of impatience, there are equally 
potent differences in ability, industry, luck, and fraud. By 
abihty is meant one's capacity to earn ; by industry, the 
use of this capacity. Examples of getting rich from ability 
and industry are very common. Almost all the rich men 
in this country who have made their fortunes have done so, 
in part at least, through abihty and industry. Often luck 
has aided greatly. There are many examples of miners 
who got rich in Colorado by simply stumbHng on a 
gold mine. Luck plays a larger role in the accumulation 
of fortunes than many are inclined to believe. The " un- 
earned increment " is usually a case of luck. Unforeseen 
increase in ground rents has given rise to large fortunes 
from time immemorial. It is also unfortunately true that 



482 ELEMENTARY PRINCIPLES OF ECONOAnCS [Chap. XXV 

some men have really got their start, if not their larger 
accumulations, through fraud. This has sometimes oc- 
curred through " high finance," which consists very largely 
in making contracts with one's self at the expense of others 
whose interests the double dealer, as director, trustee, etc., 
happens to control. If a man is a director in a corporation, 
and votes to have it buy materials of himself at any price 
he sets, he naturally can become rapidly wealthy at the ex- 
pense of the stockholders. Also through poHtical " graft," 
and especially through getting city franchises for gas and 
waterworks and street car companies, and through special 
tariff legislation, many men have become wealthy. Pov- 
erty, on the other hand, has often resulted not only from 
thriftlessness, but from incompetence, i.e., lack of ability, 
slothfulness (lack of industry), and misfortune or bad luck, 
and from having been defrauded by others. 

We conclude, therefore, that equality of wealth is an 
unstable condition and, even if once estabhshed, would not 
endure, because of unequal forces of thrift, ability, industry, 
luck, and fraud. 

But inequality once established tends, by inheritance, to 
perpetuate itself in future generations. The workman who 
accumulates a few thousand dollars from nothing makes it 
easier for his children to accumulate more. He gives them 
a start or a " nest egg." Recently four sons of a Con- 
necticut farmer met in a family reunion. Many years pre- 
viously the father had sent them into the world to make 
their fortune, giving each $700 to start with. When they 
met at the recent family reunion, all were worth thousands. 
The well-known woman millionaire, Mrs. Hetty Green, 
is an example of a person who inherited a large fortune 
and then accumulated more, by virtue of her low " degree 
of impatience," i.e., her preference to accumulate for the 
future rather than to spend in the present. A fortune of 
$6,000,000 was bequeathed her, and now her fortune is 
reputed to be worth $100,000,000. 



Sec. 7] WEALTH AND POVERTY 483 

Likewise poverty may be passed down from generation to 
generation. A special cause for handing down inequality 
of fortunes lies in the reduction of the birth rate among 
the rich. As we have explained, the tendency to-day is 
for the poor to have a high birth rate, and for the rich to 
have a low birth rate. There results a tendency toward an 
increase in the numbers of the poor and a decrease in the 
numbers of the rich. This result tends to exaggerate the 
differences in the per capita wealth between the two classes ; 
for in the upper classes there will be a relatively larger 
share for the few who inherit fortunes, and in the lower 
classes there will be an increasingly smaller share for the 
many. 

We see, then, that there is at least a tendency for the 
rich to grow richer and the poor to grow poorer. We may 
even go so far as to say that the richer a man or family 
becomesj the easier it is to grow richer, and that the poorer 
a family becomes, the more difficult it is to keep from 
growing poorer. Large fortunes often grow without effort. 
All that is necessary is for their owners to refrain from 
squandering. On the other hand, a family once caught in 
poverty is apt to be drawn deeper into the mire. Overwork, 
anxiety, and unsanitary surroundings bring on disease or 
disability, which robs the family of what Httle it once had. 
The opportunity of the wealthy is their wealth, and the 
curse of the poor is their poverty. " To him that hath 
shall be given, and from him that hath not shall be taken 
away even that which he hath." 

§ 7. The Limits of Enrichment and Impoverishment 

Yet there are hmits to enrichment and impoverishment. 
The ordinary downward hmit is reached when a man loses 
all his capital. He has then no source of income left except 
his own labor. When a man has succeeded in losing all 
his capital, the process usually comes to an end, because 



484 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

society, in self-protection, decrees that it shall go no farther. 
He is in most civilized lands not allowed to sell himself or 
to pledge much of his distant future services. But where 
there is no such safeguard, the unfortunate victims may 
sink into even lower stages, such as the debt servitude in 
the Malay Archipelago or Russia, and to some extent in 
Ireland ; or they may even sell themselves or their families 
into slavery. In most countries the poor come to be a 
large and permanent as well as a helpless class. 

Next, as to the upper limit. We have seen that the op- 
portunity to increase one's wealth depends upon the market 
for present and future goods, i.e., the loan and investment 
market. A hermit cannot become immensely wealthy ; nor 
can any of the inhabitants of a small island, if cut off from 
the rest of the world. The utmost that a man in an isolated 
community can own is the capital which that community has 
or can get — its land, dwellings, means of locomotion and of 
manufacture, etc. These are necessarily limited by the size 
of the community. As the market widens, the limits to 
the growth of large fortunes widen also. To-day there is 
no limit to what one man may accumulate except that he 
cannot more than " own the earth." 

This relationship between the possible size of individual 
fortunes and the size of the market to which the owner of 
the fortunes has access is important. Practically it means 
that in these modern times, when almost the whole world is 
one great market, the possibilities of individual fortunes are 
greater than ever before. Few people realize this fact ; for 
most people imagine that at any time in the world's history 
any fortune could have increased at compound interest. 
But a fortune is capital-value, and, as we have seen, capital- 
value has no power to produce income, but, on the contrary, 
is merely the discounted value of anticipated income. The 
only way a man's fortune can increase at compound interest 
is by his constantly reinvesting income as it comes in ; that 
is, exchanging it for other and later income at the discounted 



Sec. 7] WEALTH AND POVERTY 485 

values of the latter. But evidently he must find sellers of 
some such other and later income before he can buy it. 
His income has no power whatever of itself to create other 
income. In short, an extreme upper limit to the growth 
of any individual fortune is set by the scarcity of income- 
producing instruments available. 

The common idea that "money has power to breed 
money " leads to absurdity when applied to compound 
interest. Were it true, any person might leave fortunes to 
posterity far exceeding the possible wealth which this 
earth can hold. The prodigious figures which result from 
reckoning compound interest always surprise those who 
make the computation for the first time. One dollar put at 
compound interest at four per cent would amount in one 
century to $50, in a second century to $2500, in a third 
century to $125,000, in a fourth century to $6,000,000, in 
a fifth century to $300,000,000, in a sixth century to 15 
bullions, in a seventh century to 750 billions, in an eighth 
century to 40 trillions, in a ninth to 2 quadrillions, and in a 
thousand years to 100 quadrillion dollars. Now the total 
capital in the United States is only about 100 billions, and 
that in the world at large — even assuming that the per 
capita wealth elsewhere is as large as the United States, 
which is an absurdly large allowance — must be less than 
2 trillions, which is only one fifty-thousandth part of what 
we have just calculated as the amount at compound interest 
of $1 in 1000 years. Yet 1000 years is only half the time 
since the Christian era began. In 2000 years the $1 would 
amount to 100 quadrillion times 100 quadrillions, which is 
many, many times as much as a world composed of solid 
gold. Needless to say, such a prodigious increase of wealth 
could never actually take place, for the simple reason that 
this is a finite world. The difficulty lies, not simply in the 
reluctance of people to provide for accumulation several 
centuries after their death, but also to the fact above 
mentioned, that large accumulations would reduce oppor- 



486 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

tunities for reinvestment and therefore reduce the rate of 
interest. The attempt, for instance, to invest trillions 
every year would drive up the prices of all investable prop- 
erty, i.e., all capital. To invest such sums would practically 
require the purchase by the rich man of all existing railways, 
steamships, factories, lands, dwellings, etc. But many of 
the present owners of these, having already sold a large 
portion of their property and thus reduced their degrees of 
impatience to equality with the prevaiHng rate of interest, 
would not part with more except at prices so high that 
the purchaser would make little or no profit or interest on 
his investment. Thus, the approach toward the limit of 
investment would reduce the rate of interest and retard, and 
finally altogether prevent, further accumulation. 

There are some interesting examples of long-continued 
reinvestments. Benjamin FrankHn at his death, in 1790, 
left £1000 to the town of Boston and the same sum to 
Philadelphia, with the provisos that they should accumu- 
late for a hundred years, at the end of which time he calcu- 
lated that at five per cent each legacy would amount to 
£131,000. In the case of the Boston gift, it actually 
amounted, at the end of the century, to $400,000, and has 
since accumulated to about $600,000. The sum received by 
the city of Philadelphia has not increased so fast. 

Another interesting case of accumulation is that of the 
Lowell Institute in Boston, which was founded in 1838 by 
a bequest of $200,000, with the condition that ten per cent 
of the income from it should be reinvested and added to the 
principal every year. A peculiarity of this provision is that 
it applies in perpetuity. There is, therefore, theoretically, 
no Umit to the future accumulation thus made possible, 
and it would be interesting to know what will be its 
history in future centuries. The fund, after only 67 years, 
amounted to $1,100,000. Another example is the " Sailors' 
Snug Harbor" of New York, which has outgrown the work 
orginally intended and is now applying to the courts for relief. 



Sec. 8] WEALTH AND POVERTY 487 

§ 8. The Cycle of Wealth 

With a world market for investment, we have every pros- 
pect of a great increase in private fortunes in the next few 
centuries. But practically the limit reached in the history 
of most large fortunes is only a very small part of the high 
Umit we have set, that of " owning the earth." There is 
usually a reaction against the desire to accumulate. Each 
reduction in the rate of interest tends to check the desire 
to accumulate. Moreover, this desire soon palls. A 
multimillionaire recently left his fortune to accumulate 
until 2 1 years after the death of his youngest heir, with the 
intention of accumulating by that time the largest fortune 
on record. But his heirs much preferred to use it during 
their own Hfetime, and succeeded in breaking the will. 
Even had they not succeeded, those who finally came into 
the fortune would probably have begun, at least in a few 
generations, to dissipate it; for the usual effect of great 
wealth is to produce habits of spending. 

It has already been noted that one's rate of impatience 
for future income, given a certain prospective income- 
stream, will be high or low according to one's past habits. If 
a man has been accustomed to simple and inexpensive ways, 
he finds it fairly easy to save and ultimately to accumulate 
a considerable amount of property. These habits of thrift, 
being transmitted to the next generation, result in still 
further accumulation, until, in the case of some of the de- 
scendants, afHuence or great wealth may result. But if a 
man has been brought up in the lap of luxury, he may have a 
keener desire for present enjoyment than if he had been 
accustomed to the simple Hving of the poor. The effect of 
this factor is that the children of the rich, who have been 
accustomed to luxurious Hving, and who have inherited 
only a fraction of their parents' means, and often lack their 
ability and business training, will, in attempting to keep up 
the former pace, be compelled to check the accumulation 



488 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

and even to start the opposite process of the dissipation of 
their family fortune. It requires a certain amount of ability 
merely to maintain a fortune. Bad investments carelessly 
entered into are often the means of impairing or even anni- 
hilating a fortune. And then the unfavorable effects of 
luxury begin. A few years ago there came to this coun- 
try an Englishman who had inherited a large fortune, but 
who had also inherited the desire to indulge himself in the 
present to the full extent of his capacity. To defeat the 
effects of this desire, his parents had left him only the in- 
come of their v/ealth " in trust " (and it is not an unusual 
thing in England, where there are spendthrift sons, to leave 
property so that they may use only the income). Never- 
theless, this man contrived, by chattel mortgages and in 
other ways, to spend a good deal more than the interest 
annually accruing, and he was always in debt and in trouble. 
The product of such a course is, sooner or later, what is 
called a " shabby genteel " class. Eventually people in 
this class will have to overcome their pride, go to work, 
and become laborers — and often common laborers. After 
a few generations of poverty and the illiteracy which goes 
with it, the wealth -holding ancestry is forgotten. It is said 
that examples of such ancestry are common among laboring 
men, and would be more generally recognized were it not 
for the loss of records which is the inevitable accompani- 
ment of illiterate poverty. 

Thus the limits set by scarcity of investments (i.e., 
scarcity of purchasable instruments or shares in them) to 
the possible growth of large fortunes are always far higher 
than the vast majority of fortunes ever approach. Most 
fortunes rise and then fall, the turning point being due to the 
abandonment of thrift and the substitution of thriftlessness 
which the fortune itself sooner or later engenders. An old 
adage has put this observation in the form, " From shirt 
sleeves to shirt sleeves in four generations." We have no 
inheritors to-day of the fortune of Croesus, who, in his day, 



Sec. 9] WEALTH AND POVERTY 489 

was supposed to be a wealthier man than Rockefeller, not 
only in proportion to the wealth of his time, but absolutely. 
A man with a start of that kind ought to have been able to 
make the fortune increase rather than decrease with the 
future, and yet we know of no heirs to that fortune. To-day 
we have a large number of wealthy families in this country, 
but most of them are only one generation old! Thus the 
very rich families, so far from growing rich indefinitely, 
usually do not even continue rich more than a few genera- 
tions, but grow poor, arriving, too, at that condition without 
the vitality or the character necessary to retrieve themselves. 

Likewise, at the opposite extreme, it does not always hap- 
pen that the poor grow poorer or even remain poor. Just 
as wealth often relaxes thrift, poverty sometimes stimu- 
lates thrift. The children of the poor then become fired 
with ambition to get on in the world simply because they 
are poor. These people rise from the ranks, and rise rap- 
idly. It should be noted, however, that unlike the down- 
ward movement of large fortunes, this upward movement 
is the exception, not the rule. It may be that ninety per 
cent of large fortunes reach a maximum and decline, but 
it is doubtful if one or two per cent of the poor reach a 
minimum and rise. Many fall into pauperism or die. The 
vast majority simply remain poor. 

We see, then, that while it is very easy for those who 
have once reached the top of the economic strata to stay 
at the top, this result seldom occurs, chiefly because of 
their conversion from savers to spenders ; and while re- 
versely it is very easy for those who once reach the 
bottom to stay at the bottom, they do not always do so, 
chiefly because of their conversion from spenders to savers. 

§ 9. The Actual State of Distribution 

The churning up of society resulting from saving and 
spending and the other causes above mentioned neutralizes 



490 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

the tendency we have mentioned for the rich to grow richer 
and the poor to grow poorer, and, what is more important, 
it prevents — to some extent — the establishment of wealth- 
castes by continually changing the personnel of wealth and 
poverty. The individuals of society are like goldfish in an 
aquarium. Those once started upward continue to ascend 
for a time, whereupon they start down again. Those once 
started downward continue to descend until perhaps they 




reach the bottom, whereupon they (may) start up again. 
To complete the figure, we must suppose the shape of the 
aquarium to be like a bell, very small at the top and very 
large at the bottom. There is room for only a few at the 
top, and the struggle of many to get there makes it difficult 
for any, while it makes it easy for all to descend. There is 
most room at the bottom, and consequently there is less 
change there than anywhere else. Reversely, at the top 
there is most change. The constant changing of position in 
this bell jar, while of great moment to the individual, does 
not greatly affect the distribution of society as a whole. 
There will always be about the same proportion of fish at 
each successive stratum. Professor Pareto has, in fact, 



Sec. io] WEALTH AND POVERTY 49 1 

represented the distribution of wealth by a bell-shaped 
figure which he calls the social pyramid. This is shown in 
Figure 48. The number of people having an income be- 
tween Oa and Ob is represented by the contents of the bell- 
shaped vessel between the plane of aV and the plane of 
b^b^\ The social pyramid represents the fact that the 
larger the size of a fortune, the smaller the number of people 
who have it. There are many more at the bottom than at 
the top. We have no exact statistics for this country, 
but a rough popular estimate states that over half of our 
population have incomes of less than |6oo per year, and of 
the remaining half about half (i.e., one fourth of the whole 
population) enjoy incomes between $600 and $1200, and 
the other half (i.e., the remaining fourth of the whole popu- 
lation) have incomes over $1200. 

§ 10. The Inheritance of Property 

The frequency of changes in fortunes, whether up or down, 
will differ greatly in different countries according to the 
ages of the countries, and their laws and customs. Among 
these factors the laws and customs as to the inheritance of 
property are of great importance. If there is an equal distri- 
bution among the children of the rich, the fortune is pretty 
sure to run itself out in a few generations or centuries ; but 
in England this result is prevented by giving to the oldest 
son the bulk of the estate and cutting everybody else off 
with small stipends. The effect of this custom is to main- 
tain the family dignity and the integrity of the large estate. 
In this country there are signs that we are gradually chang- 
ing toward this English custom by which a rich man, instead 
of dividing his fortune evenly, leaves the bulk of it to one 
of his heirs. Such a change in testamentary custom will 
furnish a new and powerful tendency for existing inequal- 
ities to be accentuated and perpetuated. 

One of the special problems connected with inheritance 



492 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXV 

is that of the control over wealth a man should be allowed 
to exercise after he has died. This problem has frequently 
been under discussion. It is sometimes called the problem 
of " the dead hand." Out of this problem grew the " statutes 
of mortmain " ; and also the common law rule that no testa- 
tor can " tie up " his estate beyond " lives in being " at the 
time of his death plus 21 years. This common law rule ap- 
plies, however, only to so-called " private " bequests. To 
escape its operation a rich man very often leaves his fortune 
to some " charitable " foundation. But as it is ill advised to 
leave a fortune in the hands of private persons for a number 
of generations, so it has been found ill advised to leave for- 
tunes in perpetuity in any shape whatever ; for the result 
is that after a few generations it is impossible to carry out 
the instructions of the donor without doing harm — how- 
ever good his intentions. Conditions will have come about 
which the donor could not foresee or provide for. In Nor- 
wich, England, for instance, there was left many generations 
ago a small sum to support a preacher for the Walloons, who 
should utter a sermon in Low Dutch every year at a certain 
time. That provision is still carried out, although there are 
no longer any Low Dutch in tliis place. There is no one to 
understand the sermon, and yet it is preached every year. 
Recently the preacher has learned one sermon by heart and 
repeats it every year in order to receive his remuneration. 
In 1862 a lady died in England and left a fortune to be 
used for the teaching of the doctrines of Joanna Southgate. 
The latter had had a large rehgious following in England, 
but at this time, 1862, there was not a single soul in Eng- 
land who believed in her doctrines. Here was the curious 
spectacle, therefore, of a fortune being left in the hands of 
trustees, no one of whom could be found who believed in 
these doctrines. In 1587 a certain man died leaving to 
the almshouse of Suffolk certain real estate, the income 
of which was then £113. The income at present is £3600, 
far more than the institution can use, and the trustees do 



Sec. io] wealth and POVERTY 493 

not know what to do with it. The result has been to make 
the almshouse a mecca for all poor people for miles around 
and to pauperize the neighborhood. 

The custom of making wills is one that is handed down 
to us from the Roman days. Regarding wills, there were 
no laws in ancient Germany, no provisions in the Levitical 
laws of the Jews, none among the Hindus, and only slight 
traces among the ancient Greeks. When we talk of the 
■ sacredness of private property and the right to dispose of 
it by will, we are merely expressing our loyalty to the 
particular custom under which we now happen to live. 

It may be that in the future a remedy for some of the 
present evils connected with the ownership of wealth may 
be found by limiting or regulating the inheritance of wealth 
as to time or amount, by inheritance taxes, by limiting 
private ownership in certain perpetuities, by substituting 
leaseholds for perpetual franchises or for unencumbered 
titles in mineral lands, or even in all lands. There is much 
to be said on both sides of these proposals, but it is no part 
of our present task to enter upon their discussion. 



CHAPTER XXVI 

WEALTH AND WELFARE 

§ I. True and Market Worth 

An often-quoted passage from the Bible states that 
" the love of money is the root of all evil." Another states 
that "it is easier for a camel to go through the needle's eye 
than for a rich man to enter into the kingdom of heaven." 
On the other hand, poverty has always been regarded as 
an evil. Agur prayed that he should be given neither 
riches nor poverty. This is the theory of the golden mean. 
Still another view is that while, absolutely, wealth is good 
and the more of it per capita the better, yet its unequal 
distribution is an evil. This is the view of the socialists. 

In all these views there is some truth. Extreme wealth 
and extreme poverty are ahke evils, and the disparity be- 
tween the extremes is also an evil. Moreover, besides these 
evils dependent on the quantities of wealth are other evils 
dependent on the qualities of wealth. But how can it be 
that wealth, which is merely the physical means for satis- 
fying human wants, can ever do harm? We have escaped 
this question hitherto because we have accepted wealth, 
so to speak, at its market valuation. As was explained at 
the outset, prices are determined by the actual desires of 
men, and, when seeking to explain prices as they are, we 
were not obliged to inquire as to whether the desires which 
explain them are foolish or wise, good or bad. There was 
no need to distinguish between the desires which fix the 

494 



Sec. 2] WEALTH AND WELFARE 495 

prices of Bibles and those which fix the prices of obscene 
literature. Now, however, we propose to go a little deeper 
and to point out instances in which " desirability" is short- 
sighted and foolish, and in general to point out the various 
ways in which market valuations fail to give a true picture 
of actual worth. As we have seen, market valuations of 
fortunes do not even show their comparative desirabilities, 
because of the wide differences between the marginal 
desirabilities of money to different people. The marginal 
desirability of money decreases rapidly with an increase of 
wealth, so that — beyond a comfortable competence — the 
addition of millions means little that is really desirable. 
In fact, to some men like Mr. Carnegie, swollen fortunes 
become a burden and responsibility rather than an addition 
to personal gratification. 

§ 2. Evils Connected with the Quantity of Wealth 

That extreme poverty is an evil needs no proof. We 
shall, therefore, not discuss the problem of poverty. The 
chief causes of poverty we have already shown, and its 
remedies lie beyond the scope of our discussion. Suffice it 
to say that the problem is the greatest of all practical 
economic problems and is justly claiming a large share of 
the attention of philanthropists and reformers. Among 
the remedies or partial remedies suggested are socialism, 
old-age pensions, compulsory workmen's insurance, regu- 
lation of hours of labor, better housing, abolition of disease, 
education in thrift, profit-sharing, cooperation, monopo- 
lization and regulation of labor by trade unions. 

At the opposite extreme lie the opposite dangers and 
evils of great wealth. If the poor are too hard working, 
the rich are too idle. If the poor are underfed, the rich are 
overfed. If the poor have the discomforts of squalor and 
shabbiness, the rich have the discomforts of excessive 
attention to personal appearance. If the poor suffer from 



496 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XXVI 

overcrowding, the rich suffer from the burden of overgrown 
estabHshments. If the poor drink alcoholics to get rid of 
fatigue, the rich drink them to get rid of ennui. 

Not only does each extreme have its evils and dangers, 
but the unequal distribution of wealth has evils and dangers 
of its own. One of these is the perverted use of great 
wealth in a manner to humiliate, degrade, or demoralize the 
poor. Unequal distribution of wealth produces a caste feel- 
ing, breeding contempt for the poor by the rich, and envy 
of the rich by the poor. Corresponding to differences in 
wealth grow up differences in the mode of living, education, 
language, and manners, differences which distinguish the 
" gentleman " and " lady " from the common herd, and 
which gradually become confused with innate differences, 
which are quite another matter. Aristocracies are almost 
alwa3^s founded on wealth and are therefore almost always 
on a false basis. There are undoubtedly wide differences 
between men. If so-called aristocrats were really all the 
name would imply, the " best " in body, mind, and heart, 
much could be said in favor of their segregation from the 
" vulgar " crowd, and the development from them of a 
better race of men. But a plutocratic aristocracy is based, 
not on what men are in themselves, but on what they possess 
outside of themselves. 

Because of the differences in wealth, the poor serve the 
rich. The relation of master and servant is not simply a 
commercial relation. It also represents a supposed differ- 
ence in caste. 

Probably the worst demoralization of the poor, growing 
out of inequalities of wealth, is the prostitution of the 
daughters of the poor for the sons of the rich. Competent 
students of prostitution believe that it rests on this economic 
basis. For the white-slave traffic most people are blaming 
those who engage in it, just as for drunkenness most people 
blame the saloon keeper. Doubtless these agents have 
their share of moral responsibihty. Yet they are merely 



Sec. 2] WEALTH AND WELFARE 497 

the brokers in the business. The demand and supply are 
the important factors, and the demand and supply arise 
chiefly because of the imequal distribution of wealth. 

Next to the poor selling their souls comes selling their 
votes. Bribery and political corruption are largely due to 
differences in wealth. In a democracy we have the ideal 
conditions for such perverted uses of wealth. In a democ- 
racy there are two great powers, the power of the ballot 
and the power of the purse. The power of the ballot rests 
with the poor because of their numbers. The power of 
the purse rests with the rich. Nothing could be more 
natural than that the unscrupulous representatives of these 
two powers should contrive to get together for mutual 
advantage. They need not meet directly. The perverted 
politician intervenes as a broker. Many of the city govern- 
ments of the United States exemplify this condition. These 
politicians make, on the one side, a business of controlling 
the votes of the poor, partly by bribery, partly by dispens- 
ing " charity," and partly by activity in party organiza- 
tions ; and, on the other side, they make a business of 
" holding up " the capitalists who want franchises for street 
railways, water, gas, electric light, or telegraph or special 
tariff legislation. The unscrupulous capitalist finds it ad- 
vantageous to pay toll to the politician, either by actual 
bribery or by stock in corporations, or by what a politician 
recently called " honest graft " in the form of " tips " or in- 
side information as to the stock market, real estate transac- 
tions, etc. Some of the politicians in our state legislatures 
and even in our national Congress are of this character. 
Some are avowed or secret representatives of capital or 
"the interests"; others, of voters or "the people." In this 
case the conflict between plutocracy and democracy becomes 
more direct and visible. But it always exists and will 
continue to exist, in some form, unless one of the two 
powers shall some day completely vanquish the other. 
Here is one of the great practical problems of the day. 



498 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

§ 3. Forms of Wealth Injurious to the Owner 

We have seen several of the evils of wealth, and in partic- 
ular some of the misuses to which wealth may be put. We 
can better understand the nature of these and other mis- 
uses if we reemphasize the fact that wealth, in its narrow 
sense, does not include the most precious of our posses- 
sions, ourselves. The evils of wealth consist largely in an in- 
crease of external wealth at the sacrifice of what may be 
called internal wealth. Emerson said : " Health is the 
first wealth." The founder of Christianity asked, " What 
shall it profit a man if he shall gain the whole world and 
lose his own soul?" Many a millionaire would willingly 
give all his millions for youth, health, or even freedom from 
pain. Many uses of external wealth practically injure our 
internal wealth. The injury may be physical or moral or 
both. It is in this regard especially that " satisfactions," 
in the economic sense, fail to measure real welfare. Indeed, 
as regards the body, we may classify satisfactions into self- 
benefiting and self-injurious. Many articles of wealth, 
though possessing commercial value, are really injurious 
to those who use them. In some cases the articles of 
wealth referred to are used almost exclusively by the rich, 
in others, almost exclusively by the poor. Among examples 
of self-injurious satisfactions or uses of wealth are the con- 
sumption of unwholesome food or the wearing of constrict- 
ing clothing or the use of dwellings injurious to the health ; 
the practice of unhygienic or immoral amusements, the use 
of narcotics, such as opium in China, hashish in India, 
absinthe in France, whisky in Ireland, and alcoholic bev- 
erages in western civilization generally. These may be 
called perverted uses of wealth, but they are very common, 
so common as to give commercial value in millions of dol- 
lars to disease-producing food factories, distilleries, saloons 
dives, gambling houses, low dance halls, and theaters, 
houses of prostitution, immoral and degrading literature. 



Sec. 4] WEALTH AISFD WELFARE 499 

The perverted satisfactions here represented are capital- 
ized like any other satisfactions. They are often paraded 
to show how wealthy a nation is, but as they weaken 
the stamina of the people and shorten their lives, they 
really lessen its satisfactions in the end. In any com- 
plete view of the subject they should be recognized as 
sources of national weakness, not strength. This is recog- 
nized in the great reform movements — housing reform, 
temperance reform, and the movement to abolish the 
*' white-slave " traffic. 

§ 4. Forms of Wealth Injurious to Society 

Other evils of wealth consist in its use by one person to 
injure another. Just as we classified some satisfactions into 
personally beneficial and injurious, so other satisfactions 
may be classified into socially beneficial and injurious. 
Examples of socially injurious satisfactions are of many 
kinds. Robbery, fraud, embezzlement, arson, and other 
criminal acts are too obvious to need more than mention. 
A burglar's " jimmy " is an article of wealth, but it never- 
theless is a means of injury to society. 

Of less obvious examples one is the exploitation of gold 
mines when their product depreciates the currency. As we 
have seen, the production of gold at a sufficiently rapid rate 
tends to raise prices. Here we find great gold fields, stamp 
mills, assay and smelting works, etc., standing in our ac- 
counts as important items of national capital. Yet, when 
they produce fluctuations and uncertainty in our monetary 
standard, they are injurious, rather than beneficial, to the 
country. While they afford means and opportunities for 
their individual owners and exploiters to make great private 
fortunes, they do not enrich a nation or the world ; for their 
effect is merely to change the numbers in which prices are 
expressed. Thus, much of the labor and capital invested 
in gold mines may be said to be socially wasted. A small 



500 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

amount of money is as good a medium of exchange as a 
large amount. If gold flows out of the gold mines fast 
enough to raise prices, the result is social harm rather 
than good, disturbing the distribution of wealth and con- 
tinually tending to precipitate a crisis. 

The gold miner's fortune is thus often made, not by an 
addition to the world's real wealth, but by an abstraction 
from the world's wealth for his benefit. In addition' there 
is a waste of labor in mining. When gold can be profit- 
ably mined far in excess of what is necessary to maintain a 
constant price level, the gold miner is, as it were, robbing 
society. Thus, even the most genuine gold brick, as to 
which there is no thought or intent to defraud, may prove 
in the end a swindle. 

Other examples of socially injurious wealth are such nui- 
sances as the " smoke nuisance," privy vaults in a city, and 
" pests " of various kinds. A factory which defiles the 
household linen and the lungs of the neighborhood is not 
an unmixed benefit. If all the injury it caused could accrue 
to the factory owner, he would put in a smoke consumer, or 
else most willingly suffer a great deduction in the value of 
his plant. Instead, he causes a great loss of value thinly 
distributed over blackened houses and an injury, never 
capitalized or measured, in the health of his fellow citizens. 
Such cases, v\^here social interests and individual interests 
do not run parallel, justify legal interference. We cannot 
allow bonfires or bad sanitation in a crowded city merely 
because many individuals want the " freedom " to have 
them, nor can we allow freedom of movement on the part 
of those carr3dng infectious diseases. 

§ 5. Forms of Wealth Used for Social Rivalry 

The other examples of socially injurious uses of wealth 
we shall mention are all cases of social rivalry or racing. 
Three special cases will be considered. 



Sec. 5] WEALTH AND WELFARE 501 

The first relates to warfare and the preparation for war. 
It is usually conceded that actual warfare is economically 
injurious. The best that the apologists for war can say 
is that it is inevitable. But it is not so well recognized 
that the economic preparation for war is an example of 
world waste, albeit an effort toward economy on the part of 
each individual nation. When Germany invested millions in 
armaments, she merely stimulated France to do the same. 
The two nations have been racing with each other ever 
since, as have other countries, including England and the 
United States. Each battleship which costs ^12,000,000 in 
the end adds practically nothing to the world's effective 
capital. Its object is to benefit one nation by increasing 
its miKtary strength relatively to other nations. But it 
does not even accomplish this object. On the contrary, 
as soon as this movement is met by the other rival nations 
and a similar battleship is added to their navies all the 
advantage which it was sought to gain is lost again and 
the various nations are in precisely the same relative posi- 
tion as before any battleships were built at all. Prepara- 
tion for war is a species of cutthroat competition. If six 
world powers, instead of investing each $12,000,000 in a 
battleship, should agree not to do so, the result would be 
to save $72,000,000 from being wasted. The case would 
be very different if the ships belonged to the merchant 
marine. In that case, the building of $72,000,000 worth 
of ships would add that much to the world's productive 
capital. The utility of merchant ships is absolute, that of 
battleships is relative. 

Thus, for the most part, the " capital " of nations, in the 
form of armaments, represents economic waste, although 
no one nation could afford to dispense with it as long as 
other nations do not. 

Our second example of socially injurious rivalry is com- 
mercial cutthroat competition. We have seen that what is 
often to the interests of individual producers is against the 



502 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

common interests of producers as a group. We may now 
add that it may be injurious to the interests of society as a 
whole. In fact, we have already noted that a patent and 
copyright have their justification in the fact that the play 
of unprotected individual interests would practically re- 
sult in discouraging or suppressing inventions and books. 
The same must often be true in other instances. Tele- 
phone competition is not only injurious to the telephone 
companies but to each subscriber, who either has to have 
two or more telephones in his house, with all the expense 
and annoyance which that arrangement implies, or has to 
remain in want of proper and easy connection with sub- 
scribers to systems other than the one he happens to employ. 
Our third example of socially injurious rivalry is perhaps 
the most important and pervasive, although the most 
subtle, of all. It concerns rivalry in wealth itself, and 
introduces us to the subjects of luxury, extravagance, social 
ambition, and vanity. Thackeray's novel, " Vanity Fair," 
is a satire on the sort of economic rivalry referred to. 
Vanity may be defined as a desire to obtain the ap- 
proval of others, and vanity leads to social rivalry. This 
may be considered as rather a broad definition of vanity, 
and it is one which does not always or necessarily imply 
any slur. The important part played by vanity in eco- 
nomic affairs is seldom realized. A case of pure vanity 
is seen when a man wants merely the badges of distinc- 
tion. For instance, the badge of the Legion of Honor 
which Napoleon established in France is much desired, 
merely as a means of obtaining the approval of other 
people. It has no intrinsic desirability. It is not be- 
cause it is beautiful that it is desired ; it is not because 
the badge can keep one warm or appease one's hunger or 
fulfill any of the primitive and individual desires of men. 
It merely appeals to the instinct to attain distinction in the 
eyes of other people. Most cases of vanity, however, are not 
so pure, but are mixed with a substratum of actual utility. 



Sec. s] wealth AND WELFARE 503 

For instance, a diamond is desired chiefly out of motives of 
vanity, but it is desired also because it appeals to the aes- 
thetic sense. It is a curious fact that as soon as we mix 
vanity with some other motive, people begin to hide behind 
this other motive and conceal the vanity of which, for some 
reason, they seem to be ashamed. When a woman wears a 
diamond hatpin, and can never, by virtue of its position, see 
it herself, what real motive is there except vanity ? Of course 
it may be said that she is an altruist in attempting to pro- 
vide an article of beauty for other people to admire ; but 
the real object, however she may condone or conceal it, is 
to display this diamond to other people and to show thereby 
that she is in the fashion or leading it and able financially 
to do so. Most articles of ornament pander chiefly to this 
form of vanity and come into existence largely and chiefly 
for this reason, although the admiration of actual beauty is 
a secondary element and a subterfuge. 

The amusements of mankind are almost always, or to a 
large extent, mixed with the motive of vanity. For in- 
stance, automobiling to-day is not always indulged in for 
the sake of sport alone, but also for the sake of display. 
Equipages have always been one of the means of displaying 
wealth. Narcotics have always been objects desired not 
merely for their drug effect, but also for the effect of display. 
The habit of using "fine wines" an expensive drinks in 
entertaining has long been one of the methods of social dis- 
play. Clothing even, and housing, are very often objects of 
vanity. In fact, historically, clothing originated as orna- 
ment, like jewelry, rather than as an actual protection from 
the weather. Even food is a matter of vanity to a certain 
extent. Feasts have been favorite occasions for the exer- 
cise of this instinct. 

A few extreme examples of ostentation will help us to 
understand the nature of vanity. Some years ago there 
was an American in Florence who carried the idea of dis- 
play in his equipage to the extreme of getting a chariot and 



504 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

having sixteen horses to pull him through the narrow streets 
of the city. Ordinarily an attempt to gratify vanity re- 
sults in the approval which is sought by the individual, 
but in extreme cases hke this it often results in disapproval, 
and this man was known in Florence for years as " that 
fool American." A well-known French count, who through 
marriage became possessed of means, gratified the instincts 
of vanity by proceeding to spend untold sums in building 
a large and useless colonnade of pillars, simply to show 
that he was able to do so. A person not long ago left a 
will providing $1,000,000 for the erection of his own tomb. 
Cleopatra once showed what she could afford by drinking 
a dissolved pearl. Pliny states that after Cleopatra did 
this she was imitated by the son of a famous actor, and 
the practice of drinking pearls became a sort of fashion 
in Rome, as to-day some men of a less subtle vanity light 
cigars with $5 bills. It was probably this practice which 
led to the phrase "money to burn." In Philadelphia not 
very long ago a lady had a carpet made with a special 
design, and when the carpet was completed she was care- 
ful to have the design destroyed lest any one else should 
have a carpet Hke hers. A well-known speculator is said to 
have bought for his wife for $30,000 a particular carnation, 
in order that it might be called by her name. In Holland, 
centuries ago, there was a furor over tulip bulbs which 
took such a hold on the people and led to such extrava- 
gantly high prices that in 1639 one bulb sold for what 
would be approximately $2000 in our money. 

The powerful influence of vanity is illustrated by the ad- 
miration people have for foreign importations. Many people 
really delude themselves with the idea that they care for an 
imported cigar or wine because they believe it to be superior 
to the domestic article. Nor is this the only species of 
vanity appeased by the purchase of foreign goods. An art 
dealer in San Francisco found that certain people preferred 
to pay $4000 in Paris for the same picture which they could 



Sec. 5] WEALTH AND WELFARE 505 

buy in San Francisco for $2000, in order that they might 
state that they bought it in Paris. Some artists of San Fran- 
cisco found it advisable, therefore, to take their pictures to 
Paris, in order that they might get higher prices from 
Americans. California wines go to Europe to be returned 
as " imported " wines. Not long ago an American who 
hves in a well-known cheese-making district in New York 
paid a very high price for an imported cheese and took 
great delight in the fact that it was imported. As a mat- 
ter of fact, it had first been exported from his own town. 
New York cigars are shipped to Key West to be reshipped 
from there as " Key West " cigars. 

The effort to produce imitations is found in the case of 
almost all articles of vanity, though the superiority of the 
" genuine article " is strenuously maintained. This is well 
illustrated in jewelry. A paste imitation of a diamond can 
never fetch the same price as a real diamond except when 
its character as an imitation is fraudulently concealed. 
If a chemical method should be developed of making a real 
diamond cheaply, the desirability of diamonds would be 
destroyed; they would immediately go out of fashion; 
the invention would be self-destructive, and the price of 
diamonds and the use of diamonds destroyed. That is, 
diamonds are desired because they are scarce and a badge 
of economic power of the people who possess them. This 
is why imitation jewelry is regarded as a sham. Paste 
diamonds may be quite, or nearly, as beautiful as real 
diamonds, but they can never be so valuable. Those who 
use them do so not because they regard them as beau- 
tiful, but usually in order to make people beheve they are 
" real " and that the possessor can afford to buy them. 
Sometimes they are worn as symbols of real diamonds kept 
for safety in bank vaults. The owners then appear at the 
opera with the imitation jewels. When spoken to of their 
jewels, these people will say that they are not real jewels, 
but are an exact imitation of real jewels which are in 



5o6 ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

the safe deposit vaults. In such cases the imitation jewels 
serve purely and simply as badges of ownership. There is 
then supposed to be no pretense involved. The wearers 
would be thought " cheating " if they possessed only the 
paste. Their virtue consists in actually having the " real 
thing," which the paste replica proclaims. . A wealthy 
woman seriously argued the question of whether a poor 
woman had a right to wear an imitation diamond. Her 
thought was that, since the poor person could not afford 
to have a real diamond to wear, the imitation diamond 
amounted to deceit. 

§ 6. The Cost of Vanity 

Now the efforts to satisfy vanity are like the efforts of 
nations to secure armaments. The chief advantage that 
social racing gives to an individual is relative and this impHes 
putting other people at a relative disadvantage. So far as 
society is concerned, the cost of keeping up the race is a total 
waste. This cost consists in the labor expended on the grati- 
fication of vanity, and shows itself in the high prices of articles 
for that purpose. The tax thus laid by society upon itself is 
enormous, and a part of it may be measured roughly by the 
annual purchases of articles of pure vanity. Yet people 
seldom complain, for the individual can see little or no 
difference between the good he gets from an article of 
vanity and the good he gets from any other article. He 
does not care much about the pace he may be setting for 
others, and he does not hold any other particular person 
or persons responsible for the pace which has been set for 
him. He looks at the world's fashion as an inevitable 
fact, and adjusts his own actions to it. Our task, however, 
is to look at the social effects of his actions on others, and of 
others' actions on him. His expenditures for vanity may 
give him the satisfaction of " cHmbing," but by as much as 
he gets ahead of others the others are left behind. They are 



Sec. 6] WEALTH AND WELFARE 507 

all in a social race to get ahead. In the scramble all are at 
great effort or expense, and in the end there is a loss of eco- 
nomic power similar to the loss by nations racing for military- 
supremacy. Undoubtedly the race stimulates the racers, 
and may do them some good as a mode of exercising their 
abilities, and even lead to useful inventions. The same 
maybe said of war. But our present purpose is to point 
out the cost, which is usually overlooked. If the true cost 
could be expressed in figures, it would doubtless amaze 
people who have never stopped to see the extent to which 
luxury and luxurious rivalry is carried. Almost all expendi- 
ture is more or less colored by it. 

We have called the extravagance which is created by the 
desire of a man to compete with his neighbor in vanity 
social racing. Now when fashion enters into the matter, 
as it almost always does, this race becomes more like a 
chase. There are leaders and followers, and the followers 
try always to overtake the leaders. When they do so, the 
leaders turn in their course in order to elude their pursuers. 
The consequence is that fashions are constantly changing 
at the hands of the leaders of fashion. The leaders of 
fashion are usually from among the richest people in the 
community, and whatever they consume, those beneath 
them in the social or economic scale wish to consume also. 

We may take, as an example, the case of russet shoes, 
which are constantly coming in and going out of fashion. 
A few years ago a gentleman was surprised to find that 
only the highest grades of russet shoes were carried on the 
market. When he asked the reason, he was told that russet 
shoes had gone out of fashion only a year or two before ; 
that now they were coming in, and the only way by which 
they could be got in was by putting the highest grades on 
the market first, because if the lowest and cheapest grades 
were put on, then the leaders of fashion would not want 
them, and if the leaders did not want them, then followers 
would not want them either. Consequently the demand at 



5o8 ELEMENTARY PRINCIPLES OE ECONOMICS [Chap. XXVI 

the top is the one to be first supplied. After this initiatory 
demand has been satisfied, the shoes are imitated in cheaper 
grades, until finally russet shoes become so common that 
the leaders refuse to wear them longer and they go out of 
fashion — only to come back again in a few years, after which 
the same cycle is repeated. 

Vanity is literally insatiable. Without vanity there 
would be little use for the fortunes of multimillionaires. 
Beyond a modest fortune more wealth would be to them 
entirely superfluous. Therefore the use to which they put 
iheir milhons is of much more moment to society than to 
themselves. If they use it to set standards of luxury, they 
are using it in a socially injurious manner. They produce 
the same effect on society as though they levied a tax on 
all persons poorer than themselves. 

The individual can emancipate himself from the expense 
of social racing by asserting his independence and " living 
the simple fife " regardless of his neighbors or their opinions 
of him. An interesting book called " One Way Out " de- 
scribes how one family " ran away from its neighbors " 
in order to start fife afresh in a less expensive environ- 
ment. By such a step the cost of living could probably 
be cut in two or reduced in an even greater ratio. 

But to most men and women such Spartan measures 
would seem a hardship rather than a saving. For them, 
no remedy for their own extravagance would be adopted 
which did not carry with it a remedy for the extravagance 
of their neighbors also. 

§ 7. Remedies for the Evils of Vanity 

We have seen that the natural remedy for cutthroat 
competition in business is combination. In the same way 
if there could be a general " disarmament," as it were, or 
agreement between the social competitors, it might solve 
the problem of social rivalry. 



Sec. 7] WEALTH AND WELFARE 509 

This declaration of truce has, indeed, been put in opera- 
tion on a small scale in schools, colleges, and clubs. A 
good instance is to be found among women's sewing cir- 
cles. When such a circle is first organized, the hostess 
gives a very simple entertainment. At the next meeting 
a rival hostess gives sorriething a Kttle more elaborate, and 
presently the members of the circle are madly racing in 
the effort to supply the best entertainment. A reaction 
becomes necessary and the ladies finally agree explicitly 
" not to serve more than two kinds of cake." 

An example of how this general disarmament works was 
seen in San Francisco at the time of the earthquake. There 
the people who lived formerly on Nob Hill in fine houses 
had to live in tents or out of doors. So far as this loss was 
concerned, it was no loss at all — at any rate, no loss at 
first — because each man was perfectly willing and liked to 
live out of doors, provided his neighbor lived in the same 
way. Yet before the earthquake any one of these people 
would have been ashamed to live in a tent because he knew 
that his neighbor would wonder or criticise. 

Very similar to social disarmament is compulsion by the 
government. The Dutch government, for the sake of the 
nation's resources, finally took a hand in the tulip craze, and 
the traffic in bulbs was stopped. History contains many 
examples of sumptuary laws designed to check social racing. 

One cure was suggested by John Rae (a Scotch economist 
writing in 1834) which is ingenious, although it has never 
been consciously put into use. He says, and wisely, that 
we cannot change this inherent ambition in human nature. 
All we can do is to turn it to some good account instead of 
letting it run to waste. He suggested that social racing 
could be made to yield a revenue to a government by tax- 
ing imported luxuries so as to make them expensive, and 
therefore desired by the wealthy and out of the reach of 
their imitators. A case in point is that of the cheap wines 
of France being dear in England because of the tariff and 



5IO ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

cost of importation across the channel, and reversely, the 
cheap wines in England being dear in France. Each was 
fashionable in the country of the other, but unfashionable 
at home. Now if a tax is able to create a fashion in this 
way, through making an article exclusive, the government 
can get a revenue by creating a fashion, and the tax im- 
posed on society by fashion could thus be made to accrue 
to the government. 

Another way is to change the fashion of fashion, so to 
speak, so that it may be made to run in more useful channels. 
One of the better forms of vanity is that which does not sat- 
isfy itself by display in the usual sense, but seeks to make a 
record of power in the financial world. In these days a man 
may advertise his wealth in other ways than by high living. 
To be known as the largest stockholder in a railway is one 
of the coveted distinctions. Again, by publishing names 
and amoimts contributed, the newspapers give distinction 
to the large contributors to charity. It is now known 
that more money can usually be raised by a public sub- 
scription list than by a church collection, where the con- 
tributor obtains no public notice. The publicity of tax 
lists even stimulates a desire, though still weak it is true, 
to have one's name near the top of the tax list. Private 
display is also taking on healthier forms. One wealthy 
American is distinguishing himself by buying works of art 
and loaning them to the great art galleries of Europe and 
America. In fact, in spite of many evidences to the contrary, 
there are some indications that display, in the old sense, is 
decreasing, especially among men. There was a time when 
men bedecked themselves in diamonds and expensive silks. 
But to-day men seldom wear jewelry or gaudy clothing. 
Business distinction takes the place of these. Even 
women are becoming ambitious to lead in other ways than 
in " society." They seek distinction in their women's clubs 
or as executives in charitable effort. There is, as a matter 
of fact, no reason why rich men and women should not try 



Sec. 8] WEALTH AND WELFARE j 51I 

to distinguish themselves by doing good, and the tendency 
in America to-day is exactly in this Hne. Rich men are 
gradually trying to distinguish themselves by their large 
benefactions instead of by their large expenditures. They 
create great philanthropic foundations and endow hospitals, 
sanatoria, Hbraries, and universities. A few years ago, in 
the city of Pittsburg, two wealthy men vied with each 
other in erecting fine buildings for the good of the city 
of Pittsburg, and one, in order to triumph over the other, 
who had put up imposing buildings in a certain square, 
purchased the square immediately adjacent at a very high 
price for the purpose of erecting a still finer public building. 
Social racing of this sort may be socially beneficial and 
is an encouraging sign of the times. At present, however, 
great wealth is as a rule either running to waste or taxing 
those who cannot keep up with it. Perhaps some day it 
may — like other great wastes — be caught and harnessed 
and made to do some of the world's work. 

§ 8. Recapitulation 

We have now completed our brief review of the elementary 
principles of economics, or the study of wealth. It has fallen 
under three heads : (i) the " foundation stones," (2) the 
determination of prices, and (3) the principles of distribution. 
Under the first head were set forth the great concepts of 
the science, namely, wealth itself, the central theme, and the 
closely connected concepts of property, benefits and costs, 
price and value, capital and income. We saw how these 
concepts are defined, and, what is more important, how they 
are related to each other. In particular, we saw that prop- 
erty rights always have a basis in tangible wealth or persons ; 
that wealth is a means, and property a right, to future bene- 
fits and costs ; and that those present valuations called 
" capital " are the net discounted values of future benefits 
less costs called net " income." 



512 ELEMENTARY PRINCIPLES OP ECONOMICS [Chap. XXVI 

These relations were found to be illustrated by the 
principles of accounting. We found two methods of com- 
bining different accounts, whether of capital or of income. 
By the method of balances we saw what part of capital 
or income belonged to the particular person or wealth to 
which the separate accounts relate ; whereas, by the method 
of couples, we saw wherein the final total capital or income 
consists. The method of couples, when all accounts of 
society are included, brings us back to the fundamental 
truth that capital consists of concrete, physical objects 
(including in its broader sense human beings) and that in- 
come consists of final satisfactions. The "couples" which 
finally cancel themselves out are, however, for the indi- 
vidual accounts, very important. They are, for capital 
accounts, the debts between man and man and, for income 
accounts, the interactions between instrument and instru- 
ment. 

We found a fundamental relation between the varia- 
tions in the income from any species of capital and the 
variations in the value of that income ; namely, that if the 
income realized exceeds the interest accrued, the capital 
will depreciate by the difference; and, reversely, if the 
income reaKzed falls short of the interest accrued, the capi- 
tal will appreciate by the difference. 

Our second task grew out of the first. The formal con- 
cepts and relations had furnished us tools of thought, but 
they had not explained the facts with which they dealt. 
They had shown us what prices and values are, but not how 
they are determined. The determination of prices thus be- 
came next the focal point of study. We found the problem of 
price-determination to be twofold, — the problem of deter- 
mining price levels and the problem of determining individual 
prices. The former is the problem of the purchasing power 
of money, and depends, for its solution, on the study of the 
" equation of exchange." We found that the price level 
is normally proportional to the quantity of money, and in- 



Sec. 8] WEALTH AND WELFARE 513 

versely proportional to the volume of trade; it was also 
noted that the volume of deposits subject to check (rela- 
tively to the money in circulation) and the velocities of cir- 
culation of money and of deposits are important factors in 
the problem, and that the disturbance of the normal condi- 
tion of the magnitudes in the equation of exchange has much 
to do with periodical crises and depressions of trade. The 
other problem (individual prices) was again subdivided into 
two, the one relating to the prices of individual goods, and 
the other to the rate of interest. The chief key to the first 
was found in "marginal desirability," and to the second, 
in " marginal impatience," or excess of the desirability of a 
present dollar over the desirability of a future dollar. 

Having seen the principles which rule the markets of the 
world, we were ready for our third and last task, — to study 
the larger results of these forces on the distribution of in- 
come, relatively to its sources and owners. We found that 
the distribution of income according to sources fell into 
several parts, differing in mode of measurement and in 
degree of certainty. These parts may be summarized as : 
profits (whether the profits are from capital or work or 
both), capitalists^ stipulated income (whether interest or 
rent) and labor's stipulated income (wages). 

The distribution b};' owners we found depends on in- 
heritance constantly modified by thrift, ability, industry, 
luck, a.nd fraud. The topic of distribution by owners 
led to a consideration of the effects of the ownership of 
wealth on social welfare. 

Throughout the book we have confined ourselves to the 
study of principles, — the principles by which capital and 
income are related, the principles by which prices are fixed, 
the principles by which wealth or poverty is produced, the 
principles by which men and women waste wealth in useless 
rivalry. The whole study has been, as a study of scientific 
principles should be, cold and impartial. The practical 
application of the principles was not included, and the stu- 
2l 



514 .ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. XXVI 

dent was warned at the outset against taking any partisan 
position on economic questions until he had some ground- 
ing in economic principles. Now, however, that he has 
studied these principles, he is strongly advised to continue 
the subject in other books devoted to practical appKcations. 
The chief use of a study of principles is as a preparation for 
the study of their appHcation; and, unless educated men 
use their knowledge of principles as a means of influencing 
public opinion on economic problems, the solution of these 
problems will be left to those who neither understand nor 
recognize the existence of any economic principles. Every 
educated man owes it to the community to use his education 
for intelligent leadership. To-day is a time of reform move- 
ments, and never before was there greater need of intelligent 
leadership in those movements. This book will not have 
fulfilled its function if it does not induce the readers to 
apply its principles to their own lives and to the life of the 
nation of which their Hves are a part. Its chief object is to 
put them in a position to study and help solve the great prob- 
lems of money, tariffs, trusts, labor unions, hours of labor, 
housing and hygiene, and, above all, the problems of wealth 
and poverty. These are great problems and it will be well 
worth the reader's while to take up some one of them for 
thorough study. He will find that such a study will lead 
him into ever broadening fields of human interest. In fact, 
practical economic problems are seldom restricted to eco- 
nomics proper, but lead into the great realms of law, 
politics, and morals. This is because economics is only one 
branch of a greater subject, — Sociology. 



INDEX 



References in heavy-face type are to pages on which precise definitions are given. 



Ability, influence of, on distribution of 
wealth, 481. 

Abrasion, losses of gold coin by, 212, 214. 

Accounting, capital, principles of, 30-59 ; 
distinction between that of real and 
that of fictitious persons, 50-51; 
income accounting, 64-68; correc- 
tion of irregularities in net income by 
depreciation fund and other devices, 
67-69; how to credit and debit in, 
69-72 ; risk of omissions and errors in 
income accounting, 72-74. 

Accumulated products, the factor of, in 
determining wealth of a nation, 468, 
469. 

Accumulation of capital, a condition 
affecting volume of trade and therefore 
prices, 192, 193. 

Accuracy, limit of, in economic measure- 
ments, 20-22. 

Alcoholic beverages, impairment of 
laborers' vitality by, 446 ; an illustra- 
tion of the injurious use of wealth, 498. 

Amount marketed, definition, 263. 

Amount of income, influence of, on impa- 
tience and the rate of interest, 381 ff. 

Antitrust movement, certain economic 
conditions overlooked by, in aiming to 
compel competition, 332. 

Appraisal, definition, 16; limit of accu- 
racy in determining price by, 21-22. 

Appreciation of capital-value, definition, 
134, 136. 

Apprentice system, discontinuance of, 
448; trade schools supply place of, 
448-449. 

Arbitrage, definition, 261 ; description of 
business of, 333-335 ; analogies and 
distinctions between speculation and, 
341-342. 



Aristophanes, a statement by, of Gresh- 
am'sLaw, 221. 

Armaments, economic waste and injuri- 
ous use of wealth illustrated by, 501. 

Article of wealth, definition, 3. 

Arts, consumption of gold bullion in the, 
209, 212 ; influence of price of gold on 
its use in the, 214. 

Asking price, 15. 

Assets, definition, 40 ; effect on balance 
sheet of increase in value of, 41-44; 
effect of shrinkage in value, 45-47 ; 
exaggeration of, in stock watering, 47 ; 
shrinkage of, below liabilities, causing 
insolvency, 48-49; cash, quick, and 
slow, definition, 49 ; difference in rela- 
tion of, to Uabihties in case of real and 
of fictitious persons' accounting, 50-51 ; 
in balance sheets of banks, 166 ff. ; 
cash, in banking, may be less than lia- 
bilities, 172; lack of cash, offset by 
liabilities of business men in way of 
notes, etc., 172-173 ; form of, in banks 
must be such as to meet liabilities 
promptly, 174-178. 

Attributes of wealth, error of regarding 
as independent sorts of wealth, 13. 

Autocracies and democracies, differing 
views of, as to wealth, 470. 

Average, method of indicating general 
trend of changes in prices or quantities 
by an, 249-253. 

B 

"Bad debts," 172. 

Balance of trade, so-called "favorable" 
and " unfavorable," 8 ; influence of the, 
on quantity of money and therefore 
on prices, 204-209; principle on 
which the terms "favorable" and 
"unfavorable" are used, really a mis- 
conception, 297. 



515 



5i6 



INDEX 



Balances, method of : in combining capi- 
tal accounts, 5 1-54 ; result of following, 
in capital accounting, 54-56 ; use of, to 
solve problem of double taxation, 58; 
application of, to income accounting, 
75 ; usefulness of, in showing of what 
elements income consists, 8g-go; 
analogy of, in income accounting, with 
use in capital accounting, 90-92. 

Balance sheet, definition, 42 ; of banks, to 
explain circulating credit, 166, 167 fE. 

Bank checks, 148; explanation of class 
of circulating credit represented by, 
165 £f. ; classes which make use of, 
181, 182 ; use of, facilitates velocity of 
circulation, igg. 

Bank deposits, as one class of currency, 
148; explanation of class of currency 
represented by, 1 65-1 71 ; defense of, 
by cash reserves, 176-178; are nor- 
mally proportional to money, 180-182 ; 
disturbing effect of transition periods 
on ratio between money and, 184-185 ; 
effect on velocity of, of habits of indi- 
viduals, systems of payments, density 
of population, and rapidity of trans- 
portation, 196-202. 

Banking systems, character of, a condi- 
tion affecting volume of trade and 
prices, 195 ; influence of, on volume of 
deposit currency and on prices, 202. 

Bank notes, a circulating medium that is 
money, 148; a form of fiduciary 
money, 149; difference between bank 
deposits and, 166; defense of, by the 
government, 177-178. 

Bank reserves, 176-178; definite ratio 
preserved between bank deposits and, 
180-182, 183; relation between rate 
of interest and, 358-359; protection 
of, 403. 

Bankruptcy, 48-50; causes of, in finan- 
cial crises, 187-189. 

Banks, description of business of, 165 ff., 
originally considered as cooperative 
institutions operated for depositors, 
at a certain stage yield responsibility 
to stockholders, 173-174; limitations 
on business of, dictated by prudence 
and sound policy, 174-178; insuffi- 
ciency of cash, 175-176; a cash re- 
serve, 176-178; position of, during 
transition periods, 185 ff. ; runs on, 
188; correspondence between velocity 



of circulation of European, and density 
of population, 201. 

Barter, definition, 15, 151. 

Battleships, economic waste of, 501. 

Bears, definition, 339. 

Benefits of wealth, the, 23 ff . ; rendered 
by free human beings are called "ser- 
vices" or "work," by things are called 
"uses," 23-24; definition, 24; meas- 
urement of, 24-25 ; costs of wealth the 
opposite of, 25-26; property defined 
as the right to enjoy the, 27. 

Bequests, rights and limitations of, 35, 
491-493 ; illustrations of accumula- 
tion of interest by, 486. 

Bidding price, 15. 

Bimetallism, definition, 223-224 ; appli- 
cation of Gresham's Law to, 224-226; 
conditions leading to failure of, 226- 
230; conditions leading to success of, 
and prevention of complete working 
out of Gresham's Law, 230-232; 
changes in production and consump- 
tion of the precious metals under, 233- 
235 ; the "limping" standard a legacy 
of, 235. 

Birth rate, adjustment of, to amount of 
per capita wealth, 473-474 ; reduction 
of, among the wealthy helps in perpet- 
uating inequalities of distribution, 483. 

Bondholders, in a joint stock company, 
41 ; nature of investment of, as to 
safety, 425-426; distinction between 
interest received by, and wages re- 
ceived by workmen, 439 ; relation be- 
tween employers and wage-earners 
analogous to that between stockholders 
and, 455, 457. 

Bonds, calculation of present value of, 
by application of discounting prin- 
ciples, 113-124; implicit rate of inter- 
est in case of, 354-355 ; guaranteeing 
of, by stockholders, 426. 

Bond-value books, 123. 

Book credit, influence of, on velocity of 
circulation, 197-199; influence of, on 
volume of deposit currency and on 
prices, 202-203. 

Book value of capital, 44-45. 

Borrowing and lending, equalization of 
marginal rates of impatience by, 389- 

304- 
British Empire, increase of national 
wealth of, by adding to territory, 468. 



INDEX 



517 



Bullion, gold, stable relations between 
gold coin and, 209-211. 

Bulls, definition, 339. 

Business, difference between economics 
and, 2. 

Business confidence, effect of, on volume 
of trade and therefore on prices, 195. 

Buying and selling, changing the con- 
formation of an income-stream by, 

394-396- 
By-product, definition, 349. 



California, illustration in, of theory that a 
rising income-stream raises and a fall- 
ing income-stream depresses rate of 
interest, 405. 

Capital, definition, 38 ; book and market 
values of, 44-45 ; amount and dis- 
tribution of, in America, 59; position 
held by, in concepts of income and 
outgo, 60-64; income to be credited 
to, and outgo debited to, 64; link 
between income and, found in the rate 
of interest, 103 ; valuation of, from 
value of its income, 107-103 ; varia- 
tions of income in relation to,' 127 ff. ; 
accumulation of, a conditioii that 
affects trade, 192, 193 ; productivity 
theory as to interest and, "365-369 ; 
fallacious reasoning of socialists as to 
relations between labor and, 369-371 ; 
income from, 410 ff. ; fopr chief forms 
of income from : intere^, rent, divi- 
dends, and profits, 423-427 ; advan- 
tage to enterprisers of possessing, 455- 
456, 457; "living" and "dead," 461. 

Capital accounting, 39 2. ; common con- 
fusions avoidable by, 57-59. 

Capital accounts, two methods of com- 
bining, by balances and by couples, 
51-54- 

Capital-balance, definition, 40 ; con- 
sideration of case of an increasing, 41- 
44 ; of a decreasing, 45-48 ; amount 
necessary to make a business safe, 48. 

Capital-goods, definition, 39. 

Capitalists' profits, implicit rent so 
called, 412, 434. 

Capitalizing income, 107-108; applica- 
tion of principles to valuation of bonds, 
1 13-124. 

Capital property. See Capital goods. 



Capital- value, definition, 39 ; derivation 
of, from income-value, 107-108; rela- 
tions between interest accrued, in- 
terest taken out, and, 116, 121, 127- 
132 ; confusions to be avoided in con- 
cepts of interest accrued, interest taken 
out, and, 132-136; risk element in 
determining, 138-140. 

Capital wealth. See Capital goods. 

Captains of industry, 459-460. 

Cash, insufSciency of, to be distinguished 
from insolvency, 49; bank's assets in, 
may be less than deposits, 172; 
risk of insufficiency of, the greater, the 
less the ratio of the cash to the de- 
mand liabilities, 175 ; illustration of 
insufficiency of, 175-176; mainte- 
nance and regulation of a reserve, 176— 
178; adjustment of, to bank deposits, 
180-182. 

Cash assets, definition, 49. 

Cash drawer, debiting and crediting the, 
in income accounting, 69-72. 

Cash payments, influence of system of, 
on velocity of circulation, 197-198. 

Certificates of ownership, definition, 32. 

Chance, element of, in capital accounting, 
138-140. See Risk. 

Charging, influence of habit of, on ve- 
locity of circulation, 197-199; influ- 
ence of habit of, on volume of deposit 
currency and on prices, 202-203. 

Checks. See Bank checks. 

China, small per capita wealth of, 470. 

Circulating credit, definition, 165; ex- 
planation of, 165-171 ; the basis of, 
is the concrete, tangible wealth of the 
world, 171-174. 

Circulating media, definition, 148 ; classi- 
fication and amount of, in the United 
States, 150-151. 

Circulation of money, significance of, 
151 ; method of obtaining velocity of, 

152-153- 

City and country contrasted as to veloc- 
ity of circulation, 201. 

Classification of wealth, 9-11. 

Clearing the market, meaning of phrase, 
278; of loans, by automatic adjust- 
ment of rate of interest, 398-400; 
application of principle of, as applied 
to labor, 443-444. 

Coinage ratio, meaning of, 224 n. 

Colbertism, fallacy of, 8. 



5i8 



INDEX 



Combinations, trade, effect of, on prices, 
1 95 ; issue of stocks and bonds by, 
tends to raise prices, 203 ; may result 
from cutthroat competition, 322; chief 
causes of, 331-332 ; restrictive meas- 
ures should be directed toward control, 
not to restoration of competition, 332. 

Commercial paper, rate of interest on, 
402. 

Commodities, definition, 9. 

Competition, a condition of perfect, 
260-261; "cutthroat," 321 ; result of 
" cutthroat," may be monopoly or com- 
bination, 322 ; monopoly defined as 
absence of, 329; potential competi- 
tion, 330 ; may be an evil, as when of 
the cutthroat kind, 331 ; between 
employer and employee, 456-457. 

Complementary articles, attributes and 
price movements of, 347-348. 

Compound interest, results obtainable 
by computing, 485-486. 

Conservation of health, 446-448, 498. 

Conservation of land, 468. 

Contracts, retarding of adjustment of 
prices by, 248. 

Copyrights, a necessity, to avoid cut- 
throat competition, 331. 

Costs, fixed, definition, 323 ; running, 
323; general (or overhead), 327; 
particular, 327; competition of, 348- 
350. 

Costs of wealth, definition, 25-26; 
measurement of, 26 ; are the items con- 
stituting outgo, the negative of in- 
come, 62 ; do not consist of money 
but may be measured in money, 63 ; 
ultimate item of cost is labor cost or 
efforts, 98-99. 

Couples, method of : in combining capital 
accounts, 52-54; ultimate result of, a 
list of articles of actual wealth owned, 
54-56; use of, to solve problem of 
double taxation, 58; applied to 
income accounting, 75-76; usefulness 
of, in exhibiting amount of income con- 
tributed from each capital source, 89- 
90 ; analogy of, in income accounting, 
with use in capital accounting, 90-92. 

Credit, mistake of regarding, as adding to 
wealth of community, 57; definition, 
165 ; basis of, found in the tangible 
wealth of the world, 171-174. 

Credit cycle, description of course of a. 



184-191 ; time for completion of, 
usually about ten years, 1 90-1 91. 

Crediting and debiting, method of, 69- 
72. 

Crises, description of, 186-191 ; historical 
examples to illustrate, 190; proper 
adjustment of rate of interest would 
avert, 363. 

Currency, definition, 148; two classes 
of, money and bank deposits, 148; 
two types of exchange which consti- 
tute the circulation of, 178 ff. 

Curves, discount, 108-112; of demand 
and supply, 263 ff. ; of individual 
demands, 279, 280; desirability, 291- 
294 ; of marginal desirability of money, 
299-300; of supply, 304—306, 312-317. 

Cutthroat competition, conditions result- 
ing in, 317-321 ; the ending of, 323; 
an example of socially injurious rivalry, 
501-502. 

Cycle, of prices, 184-191 ; of wealth, 
487-489. 

D 

Darwin, Charles R., "natural selection" 
theory of, 474-475. 

Death rate, increase of, with increase of 
population beyond a certain p>oint, 
471-472. 

Debt limit of cities, 32. 

Degeneration, danger of, from modem 
conditions relative to population, 476. 

Demand, schedules of, 261-263 ; re- 
lations between supply and, repre- 
sented by curves, 263 ff. ; shifting 
of, 268-277 ; the influences behind, in 
the way of desirabiHty, etc., 278 ff. ; 
schedules to show that the total de- 
mand at any price is the sum of the 
individual demands at that price, 278- 
281 ; the foundation of, is desires or 
wants, 300-302 ; ultimate factor of, 
found to be satisfactions, 351-353. 

Demand at a given price, meaning of 
term, 261—262. 

Demand curve, definition, 265. 

Demand schedule, definition, 261-262. 

Density of population, influence of, on 
velocities of circulation and on prices, 
201. 

Deposit currency, 148. 

Deposit-rights, 170. 

Deposits. See Bank deposits. 



INDEX 



519 



Depreciation, concept of, 134-135; 
is excess of income taken out over in- 
terest accrued, 134, 136. 

Depreciation fund, definition, 67; a 
device for standardizing income, 
136-137- 

Desirability, definition, 281-282; total 
and marginal, 283 ; illustration of dis- 
tinction between total and marginal, 
283-285 ; an increase in the quantity 
of goods under consideration results in 
a decrease in the marginal desirability, 
286; relation of market price to, 204 
fi. ; surplus desirabiUty, 295-2g7 ; eSect 
of concept of, on our views of both 
foreign and domestic trade, 297-298; 
prime necessity of correcting money 
comparisons when comparing desira- 
bilities, 298-300 ; difficulty of measur- 
ing this real concept, 301 ; why meas- 
urement in terms of money is 
imsatisfactory, 301. See also Margi- 
nal desirability. 

Desires, the foundation of demand dis- 
covered to lie in, 300-302. 

Diamonds, vanity and socially injurious 
rivalry illustrated by wearing of, 503. 

Diet, impaired vitaUty from wrong 
habits of, 446-447. 

Discount curve, the, 108-112. 

Discounting income, definition, 108. 

Distribution of income in time, defini- 
tion, 379 ; influence of, on impatience 
and the rate of interest, 379-381 ; 
distribution relatively to the agents 
or instruments of production, 410-463 ; 
relatively to those who own and enjoy 
it, 464-493- 

Distribution of wealth, the problem of, 
465 ; among nations, 467-476 ; among 
individuals, 476-483 ; if equality of, 
could be established, it would prove 
an unstable condition, 478-483 ; influ- 
ence on, of rate of impatience, ability, 
industry, luck, and fraud, 479-482 ; 
graphic representation of, by bell- 
shaped figure, 490-491 ; influence of 
inheritance of property on, 491-493. 

Dividends, income from capital in form 
of, 424; elements of risk and varia- 
bility in, 424-425. 

Division of labor, definition, 193; 
improvement in workingmen's effi- 
ciency by, 449-450; personal and 



geographical, 450; disadvantages of, 
and suggested remedy, 450-45 r . 
Double taxation, due to confusion be- 
tween wealth and property, 34; solu- 
tion of problem of, by use of methods 
of couples and balances, 57-58. 



E 



Economics, definition, 1 ; total difference 
between business and, 2 ; at bottom 
treats simply of efforts and satisfac- 
tions, 98-100 ; a branch of the subject 
of sociology, 514. 

Education, reason of importance of a 
general, for the workingman, 451. 

Efficiency of labor, 444 fl". ; the greater 
that of workingmen, the greater the 
amount of income they receive, 
444-446 ; methods of increasing : by 
improvement in physical and mental 
vitality, in trade education, and in 
organization and division of labor, 
446-449. 

Efforts, or labor costs, are the ultimate 
item of cost, 77, 98-99, 142, 306-307; 
in final analysis, prices are dependent 
on satisfactions and, 351-353. 

Employers, are workmen whose wages 
come in form of profits, 454—455 ; 
relation of, to employees a comple- 
mentary one rather than a competi- 
tive, 457-458. 

Enjoyable income, the stage of, 97-98. 

Enterprisers, definition, 187, 433; 
position of and parts taken by during 
transition periods, 187, 189; advan- 
tages to, of possessing capital, 455- 
456, 457 ; select class formed by, and 
reasons, 457; relation between wage- 
earners and, generally a complemen- 
tary one, 457-458. 

Enterprisers' profits, 433, 434; wages 
and, 454-458. 

Equality of distribution of wealth, course 
of events in case of, 478-483. 

Equation of exchange, definition, 152; 
expressed arithmetically, 152-156; 
expressed mechanically, 156—159; ex- 
pressed algebraically, 159-160; effect 
of including bank deposits or circu- 
lating credit in the, 179-180; periods 
of transition for the, 184 ff. ; use of 
index niunber in, to ascertain general 



520 



INDEX 



trend of changes in prices or quantities, 
250-253. 

Essars, Pierre des, cited on population 
and velocity of circulation, 201. 

Eugenics, suggested remedy for degen- 
eration among population, 476. 

Exchange of wealth, definition, 14; 
is really an exchange of benefits, 25 ; 
defined as interactions which change 
the ownership of wealth, 81 ; consists 
of two transfers, 81 ; three groups of 
exchanges :, barter, exchange of money 
against money, and purchase and sale, 
151; equation of, 151- 160; six pos- 
sible types of, 178. See Equation of 
exchange. 

Exchangeability, degrees of, of goods 
before money is reached, 147-148; 
qualities of primary money which 
make for, 150. 

Expectation of life, effect of, on impa- 
tience and therefore on rate of interest, 

375, 377- 
Expenses, fixed and running, 323-324. 
Explicit rate of interest, definition, 354. 
Explicit rent, definition, 412. 
Explicit wages, definition, 433. 
Exportation and importation of money, 

influences operating through the, 

which affect quantity of money, 204- 

2og. 
Express money orders, 166. 



Fictitious person, definition, 40; dis- 
tinction between accounting of a real 
person and of a, 50-51 ; method of 
reckoning income of, 71-72 ; double 
entry in accounts of, 92-05. 

Fiduciary money, definition, 149. 

Final or enjoyable income, definition, 
97. See Income. 

Fixed costs, 323-324 ; have no effect on 
supply after they have been once in- 
curred, 324-326 ; therefore have no 
influence on prices, 326 ; how general 
costs differ from, in effect on supply 
curve, 328. 

Flow of goods, definition, 37; income 
consists of a, 38. 

Food substitutes, sympathy in move- 
ment of prices among, 346. 

Foreign importations, influence of vanity 



illustrated by admiration for, 504- 
505- 

Foreign trade, influence of, on quantity 
of money and on prices, 204-209; 
misconception as to "favorable" and 
"unfavorable" balance of, 297. 

Foresight, inadequacy of, as shown in 
only partial adjustment of rate of 
interest to price level, 361-362 ; 
influence of, on rate of interest, 362- 
363, 375-376 ; countries cited to show 
conditions where absent, 404-405 ; 
possession of, by enterpriser-capital- 
ists, 455, 457. 

France, position of, regarding population, 
469. 

Franchises, perpetual, problem of, 35. 

Franklin, Benjamin, bequests by, illus- 
trate long-continued reinvestments, 
486. 

Fraud, may play a part in accumulation 
of wealth, 481-482. 

Freedom of trade, relation between, and 
volume of trade and therefore prices, 
193, 194-195; equalization of prices 
by, 336-337- 

Frequency of receipts and disbxirse- 
ments, influence of, on velocities of 
circulation and on prices, 199-200. 

Fuel substitutes, relation between move- 
ments of prices of, 345-346. 

Futures, speculators' deahngs in, 339-341. 

Futurity, idea of, implied in definition of 
property, 27-28; element of, in con- 
sidering desirabiHties and undesira- 
bilities, 310-311, 328-329. 



G 



Galton, Sir Francis, remedy for degenera- 
tion of population devised by, 476. 

Gamblers, extreme of incaution repre- 
sented by, 426-427. 

General costs, definition, 327; differ- 
ence between fixed costs and, 328. 

Geographical differences in natural re- 
sources, a condition affecting trade, 
192, 193. 

Geographical division of labor, 450. 

Gold, reason for use of, as money, 147; 
gold coin the only primary money in 
the United States, 151 ; effect of recent 
extraordinary production of, on price 
levels, 255 ; prospects for the future 



INDEX 



521 



as to, 255-256; exploitation of mines 
when their product depreciates the 
currency an example of wealth in- 
jurious to society, 499-500. 

Goods, the collective term for wealth, 
benefits, and property, 30; capital a 
stocls of, income a flow of, 37-38. 

Goods complementary on the demand 
side, definition, 347; complementary 
on the supply side, definition, 349. 

Goods in series, definition, 350. 

Government bonds, the wealth behind, 

31- 

Greenbacks, illustration from issue of, 
to show how rise of prices helps bor- 
rowers, 360. 

Gresham's Law, that cheaper money 
tends to drive out dearer, 221-223; 
conditions under which it will not 
result in complete expulsion of the 
dearer metal, 230-232. 

Gross income, definition, 63. 

Ground rent, definition, 413 ; found to be 
the difference between the productiv- 
ity of the land and the productivity 
of land on the margin of cultivation, 
418; diSerence between, and rent of 
other instruments, 422; effect on 
taxation of difference between ground 
rent and other rent, 422 n. 



H 



Habits, effect of, on velocity of circula- 
tion and on deposits, 196-199; rela- 
tion between rate of interest and, 375, 
376-377 ; effect of laborers', on effi- 
ciency, 446-447. 

Health, conservation of laborers' and 
effect on efiiciency, 446-44S ; forms of 
wealth injurious to the, 498. 

Hedging, definition, 430-431. 

Hoarding, influence of, on velocity of 
circulation, 196—197. 

Holland, large per capita wealth of, 470. 

Human beings, exclusion of, from defi- 
nition of wealth, 3, 9-10; difSculty of 
placing correct valuation on, 22 n., 
436-440. See Labor. 



Imitations, appeasing of vanity hy, 504- 
506. 



Impatience, the source of interest, 371— 
372 ; impatience for goods, on analysis, 
resolves itself into preference for present 
enjoyable income over future enjoy- 
able income, 372-374; differences in, 
due to human nature, result in differ- 
ences in rate of interest, 375-378; 
differences in, due to differences in 
income as to distribution in time, 
amount, and uncertainties, 378-388; 
equalization of marginal rates of, by 
borrowing and lending, 389-394 ; equal- 
ization by spending and investing, 
394-396 ; effects of rate of, seen in 
inequaHties in distribution of wealth, 
479-481. _ 

Impecuniosity and velocity of circulation, 
197, 199. 

Implicit rate of interest, definition, 354. 

ImpHcit rent, definition, 412. 

Implicit wages, definition, 433. 

Imported articles and vanity, 504-505. 

Inadequacy of foresight, lack of adjust- 
ment of rate of interest due to, 361- 
362. 

Income, definition, 33 ; true concept of, as 
the flow of whatever benefits accrue 
from any article, 60—61 ; may be 
translated into terms of money and is 
subject to accounting, 62 ; gross in- 
come, 63 ; net income, 64 ; method of 
keeping income accounts, 64-68; 
avoidance of irregularity in, by creation 
of depreciation fund and other devices, 
67-69, 136-138; no net, of fictitious 
persons, 71-72 ; omissions and errors 
in reckoning a person's real, 72-74; 
the stage of final or enjoyable, 97-98 ; 
conclusion concerning, that in the last 
analysis it consists of satisfactions, 
and outgo of efforts to secure satis- 
factions, 99 ; estimated worth of final 
income annually enjoyed in United 
States, 99 ; link between capital and, 
in rate of interest, 103 ; value of, used 
to derive value of capital yielding it, 
107-108; variations of, in relation to 
capital, 127 ff. ; differences in impa- 
tience and in rate of interest due to 
differences in, as to distribution in 
time, amount, and uncertainties, 378— 
388; classified into rent and wages, 
433-434; further division into wages 
and enterprisers' profits, rent and 



522 



INDEX 



capitalists' profits, interest and divi- 
dends, 434-435 ; relative importance 
of values and quantities in compari- 
sons of, 465-466; rough estimate of 
statistics of incomes, in United States, 
491. 

Income-stream, modification of, by bor- 
rowing and lending, and spending 
and investing, 389-396 ; is determined 
as to distribution in time by adjust- 
ment between spending and invest- 
ing, 395-396. 

Index nimiber of prices, definition, 249. 

India, small per capita wealth of, 470. 

Individual demands, are derived from 
marginal desirabilities, 287 S. 

Individual demand schedules, formation 
of, from desirability schedules, 278; 
relations of, to total demand schedules, 
278-281. 

Individuals, wealth or poverty of, in a 
nation, 469-472. 

Industry, ability and, a potent means of 
acquiring wealth, 481. 

Inequalities in distribution of wealth 
among individuals, 476-483 ; tendency 
of, to perpetuate itself, 482 ; influence 
of inheritance laws on, 491. 

Inflation of currency, relations between 
money and rate of interest during, 
357-358, 359-362. 

Inhabitants, importance of factor of, in 
determining wealth of nations, 468-469. 
See Population. 

Inheritance of property, effect of, on 
distribution of wealth among indi- 
viduals, 491 ; problems connected 
with, 491-493 ; suggested regulations 
concerning, 493. 

Insolvency, definition, 48; distinction 
between insufficiency of cash and, 49; 
state of, in banking, 175; conditions 
leading to, in crises, 187-189. 

Instrument. See Article of wealth. 

Insxiffidency of cash in banking, 175- 
176. 

Insurance, as a means of avoidance of 
risk, 428-429. 

Interactions, definition, 76 ; prevalence 
of, in income and outgo accounts, 77 ; 
three chief kinds of, between two 
articles or groups of articles, 77-78; 
which change the form of wealth are 
called production, 78-79; which 



change the position of wealth are 
called transportation, 80 ; which change 
the ownership of wealth are called 
exchange, 81 ; self -canceling character 
of, 82-83 ; accounts illustrative of, in 
production, 84-88; obUteration of, 
by method of couples to discover 
uncanceled outer fringe of benefits 
and costs, 94-98. 

Interest, avoidance of confusion of rate 
of interest and, 107 ; is not a cost to 
society, but merely an interaction, 324 ; 
item of, to be considered in specu- 
lation, 342; explicit OE contract, 
and implicit, 354-355'; productivity 
theory of, 365-369; socialist theory 
of, 369-371 ; the essence of, shown to 
be impatience, 371-372 ; the futiUty 
of prohibiting, as this would mean 
prohibiting buying and seUing of all 
kinds, 396-398; land rent and other 
rent to be considered as, 422-423, 
434; prodigious figures obtainable by 
reckoning compound, 485. See Rate 
of interest. 

Interest accrued, relations between 
interest taken out and, and capital 
value, 116, 121, 127-134. 

Inventiveness, a chief quality in deter- 
mining a nation's accumulated prod- 
ucts, 469. 

Investing, definition, 395; adjustment 
between spending and, determines 
distribution in time of one's income- 
stream, 395-396. 

Investment, question of risk attached 
to every, 425 ; limitations to oppor- 
tunity for, 484-486. 

Irredeemable paper money, may circu- 
late but has its dangers, 237-238. 



Joint stock company, capital accounts of 
a, 41 ff. 



Klondike, phenomena of enormous 
interest rates exemplified in the, 405. 

Knowledge of future, increase of, a 
method of reducing risk, 427-428. 

Knowledge of technique of production, 
a condition affecting trade, 192, 193. 



INDEX 



523 



Labor, the ultimate uncanceled item of 
cost, 77, 98-99, 142, 306-307; ten- 
dency of prices of, to equalization, 
though less rapidly tlian other com- 
modities, 335, 348-349; differences in 
cost of, due to existence of noncom- 
peting groups, 349 ; socialist theory 
of right of, to all interest, 369-371; 
wages constitute the income from, 433 ; 
peculiarities of supply of, 436 ff. ; con- 
ditions governing demand for, 440 ff. ; 
the "make-work" fallacy, 451-454. 

Laborers, comparison of wages of 
English and American, 300; increase 
in wages of, makes for shorter hours, 
313—314) 436-438; classes of, accord- 
ing to productive power, 435-436; 
wages of, not being reckoned net, 
cannot be compared with interest 
received by a bondholder, 439; effect 
of rate of interest on, 442-443 ; the 
greater the efficiency of, the greater the 
amount of real income received by, 
444-446; methods of increasing 
efficiency of : by improvement in 
mental and physical vitality, by 
improvement in trade education, and 
by improvement in organization and 
division of labor, 446-449; final 
effects on, of labor-saving machinery, 
461-462. 

Labor-saving machinery, fallacious rea- 
soning shown by prejudice against, 
453 ; real economic effect of, 461-462. 

Land, definition, 9 ; rent of, 413 ff. ; pecul- 
iarities of, in being practically fixed 
in quantity and not open to classifica- 
tion as to quahties, 413-414; Ricar- 
dian doctrine of land rent, of the 
"marginal acre," 413-418; difference 
between rent of, and rent of other 
instruments, 422; the factor of, in 
national wealth, 468-469; not a 
constant source of income, as shown 
by recent conservation movement, 
468 ; on ratio between population 
and, depend the increase of national 
wealth and the increase or decrease of 
per capita wealth, 470-472. 

Land improvements, definition, 9. 

Land rent, is interest as much as other 
forms of rent, 422-423. See Rent. 



Law of decreasing cost, the, 317 n. 

Law of diminishing returns, the, 311 n. ; 
applied to agriculture, 420-421, 472. 

Law of increasing cost, the, 311 ; applied 
to agriculture, 420-421, 472. 

Law of increasing returns, the, 317 n. 

Legal tender, definition, 147. 

Level of prices, definition, 249. See 
Price level. 

Liabilities, definition, 40; difference in 
relation between assets and, in account- 
ing of real and of fictitious persons, 
50-51; in balance sheets of banks, 
166 ff. 

Life insurance, lowering of rate of 
impatience and so of rate of interest 
by, 377-378; a method of reducing 
uncertainty, 428-429. 

"Limping" standard, definition, 235; 
unsatisfactory results of, as shown in 
monetary system of United States, 
238-239. 

Loans, in banking are an exchange of 
money or credit for a promissory 
note, 168; limits to, imposed by pru- 
dence and sound economic policy, 174- 
176; method of regulating, 176-177; 
part played by, in a period of transi- 
tion, 1 85-1 91 ; influence of, on veloci- 
ties of circulation of money and of 
deposits, 198; as a means of equalizing 
marginal rates of impatience, 389- 
394 ; may be properly viewed as sales, 
394-395 ; prohibition of loan contracts 
does not prohibit interest, 396-397 ; 
automatic adjustment of rate of inter- 
est to clear the loan market, 398-400. 

Logging-camp accounts to illustrate 
interactions in production, 84-87. 

Love for posterity, effect of, on rate 
of interest, 375, 377-378; peoples 
wanting in, among whom high interest 
rates are common, 404. 

Lowell Institute bequest, 486. 

Luck, part played bj% in accumulation 
of fortunes, 481-482. 



M 



"Make- work" fallacy, definition, 451. 
Malthus, treatise on Population by, 475. 
Margin, buying on, 198. 
"Marginal acre," doctrine of the, 413- 
418. 



524 



INDEX 



Marginal cost, or undesirability, 305, 
306, 307 S. ; is the great determinant 
of market price on the side of supply, 
3og; viewed as the desire to avoid 
something disagreeable, as opposed 
to marginal desirability, the desire to 
secure something agreeable, 310; the 
element of futurity which controls, 
310-311. 

Marginal desirability, definition, 283; 
illustration of concept, 283-285; an 
increase in the quantity of goods under 
consideration results in a decrease in, 
286; marginal desirability of money, 
287 ; individual demands are derived 
from marginal desirabilities, 287-294; 
importance of, of money, 298-300; 
consideration of, with marginal cost, as 
human desires translated into money, 
310; the element of futurity which 
controls, 310-311; decrease of mar- 
ginal desirability of money, in propor- 
tion to increase of earnings, 312-314; 
of commodities and of substitutes 
for commodities tend to fall or rise in 
unison, 345-346; tendency of, of 
substitutes to stay equal, 345-346. 

Marginal rates of impatience, equaliza- 
tion of, by borrowing and leading, 
389-394; by spending and investing, 
394-396. 

Marginal unit of work, 441. 

Market, definition, 260. 

Market price, definition, 263; connec- 
tion between demand or supply and, 
268 ff. ; relation of, to desirability, 
294 fE. ; is equal to the ratio between 
the marginal desirability of any good 
and the marginal desirability of 
money for each and every buyer, 295 ; 
the determinant of, on the side of 
supply is marginal cost, 309. 

Market value vs. book value of capital, 

44-45- 
Marx, Karl, weakness in theory of 

interest of, 370. 
Measurement of wealth, 1 1 ff . ; necessity 

of homogeneity of wealth for purposes 

of, 12; limit of accuracy in, 20-22; 

measurement of benefits of wealth, 

24-25 ; of costs of wealth, 26. 
Melting and minting, influence of, on 

quantity of money and therefore on 

prices, 209-211. 



Mercantilism, fallacy in theory of, 8. 

Method of balances, definition, 51-52. 
See Balances. 

Method of couples, definition, 52. 
See Couples. 

Monetary systems, character of, a£Eects 
volume of trade and prices, 195 ; 
influence of, on volume of deposit 
currency and on prices, 202 ; opera- 
tion of, 221 ff. ; Gresham's Law, 221- 
223; bimetallism, 223-224; conditions 
when bimetallism fails, 226-230; when 
bimetaUism succeeds, 230-232 ; the 
"limping" standard, 235-238; unsatis- 
factory and complicated features of 
monetary system of United States, 
238-239. 

Money, necessity of distinguishing 
between wealth and, 5 ff. ; economic 
fallacies concerning, 6-8; use of tte 
catch phrase "making money," 9; 
definition, 15, 147 ; convenience as a 
measure of value, 18-19; concept of 
income not of necessity to be con- 
nected with, 60-61 ; all income may 
be translated into terms of, 62 ; risk 
of confusion owing to, in estimating 
real income, 73-74; degrees of ex- 
changeability of commodities before 
reaching, 147-148; checks drawn on 
bank deposits are not, but bank 
notes are, 148-149; two kinds of 
real, primary and fiduciary, 149; 
meaning of circulation of money, 151 ; 
quantity theory of, rests on fact that 
it has no definite relation to the satis- 
faction of human wants, but only the 
power to purchase things having such 
satisfying power, 164; division of, 
in two chief parts: money in circula- 
tion and money in banks, 178; def- 
inite ratio of bank deposits to, 180- 
182 ; disturbing effect of transition 
periods on ratio between bank deposits 
and, 184-185; effect of character of 
monetary systems on volume of trade 
and price level, 195 ; influence of 
balance of trade on quantity of, and 
therefore on prices, 204-209 ; influence 
of melting and minting on quantity 
of, and on prices, 209-211; influence 
of production and consmnption of 
money metals on, and on prices, 211- 
214 ; illustration by means of reservoirs 



INDEX 



525 



of influences affecting the quantity of, 
215-219; influence of monetary, 
systems in increasing quantity of, 
and raising prices, 221 &.; conclusions 
and summings-up on, 240-257 ; the 
marginal desirabiUty of,'' 287 ; impor- 
tance of the marginal desirability of, 
298-300; measurement of desirability 
in terms of, is measuring cause by its 
effect, 301 ; interest and, 354 ff. ; 
fallacy of theory that rate of interest 
is affected by quantity of, 356-359. 

Money changing, 151. 

Money in circulation, definition, 151. 

Money metals, influence of production 
and consumption of, on quantity of 
money and on prices, 21 1-2 14. 

Monopoly, effect of, on volume of 
trade and prices, 195; tendency 
toward, as a result of cutthroat 
competition, 321-322; fixing of price 
imder, 329-330; evils and advantages 
of, 330-331 ; restrictive measures 
should be directed toward control 
only, 332. 



N 



Nations, wealth of, 467-469 ; dependence 
of wealth of, on number of inhabi- 
tants, extent of territory, and amount 
of accumulated products, 468. 

Net appreciation, 134. 

Net capital, definition, 40. 

Net income, definition, 64; devices for 
making regular, 67-69; method of 
deriving a person's, 70-71 ; fictitious 
persons have no, 71-72. 

Nuisances which are examples of socially 
injurious wealth, 500. 

Number, measurement of wealth by, 12. 







Organization of labor, improvement in 
workingmen's efficiency by, 449-450. 

Ornament, articles of, a gratification of 
vanity, 502-506. 

Outgo, definition, 62. 

Overhead costs, definition, 327. 

Overpopulation, results of, 471. 

Ownership of wealth, 23, 27 ; subdivi- 
sions of, 29-30; confusion regarding 
mere certificates of, to be avoided, 



31-32; practical problems concern- 
ing, 34-36; figures of, in America, 
59. 



Pace-making among laborers, 448. 

Pareto, Professor, cited on inequality 
in distribution of wealth, 478, 490-491. 

Particular running costs, definition, 327. 

Patents, necessity of, as protection 
against cutthroat competition, 331. 

Payments, influence of systems of, on 
velocities of circulation and on prices, 
199-201. 

Per capita wealth of a nation, 469 ff. ; 
increase of population up to a certain 
ratio increases the, after that point 
decreases, 470-474. 

Political corruption, an evil attendant 
on unequal distribution of wealth, 
497- 

Population, influence of density of, on 
velocities of circulation and on prices, 
201 ; slowness in readjustments of, 
421 ; the factor of, in national wealth, 
467-468; relation of, to extent of 
national territory, 469; differing 
views concerning increase of, in autoc- 
racies and democracies, 470 ; how 
the increase of national wealth depends 
on ratio between land and, 470-472 ; 
increase of death rate when ratio of, 
to land becomes excessive, 472 ; laws 
of, in relation to wealth, 472-474; 
limit set by nature on, corresponds 
to that set on plant and animal life, 
474-475 ; the preventive check on, 
among the wealthier classes, 475-476; 
"race suicide," 476; danger of de- 
generation, and its remedy, 476. 

Post ofBce orders, nature of, as currency, 
165-166. 

Poverty, influence of, on impatience and 
the rate of interest, 381-383 ; discus- 
sion of problems of wealth and, 464 ff . ; 
of nations, 467-469; of individuals, 
469 ff. ; influence of, on birth rate, 
471-472, 473-474; passing down of, 
from generation to generation, 483 ; 
the lowest limit of, 483-484; dangers 
and evils connected with, 495—497. 

Preventive check on population, 475. 

Price cycle, description of a, 184-191. 



526 



INDEX 



Price level, a reciprocal of the phrase 
"the purchasing power of money," 
146; dependence of, on quantity of 
money in circulation, velocity of 
circulation, and volume of trade, 151- 
152; varies directly as the quantity 
of money in circulation, directly as 
the velocity of its circulation, and 
inversely as the volume of trade 
done with it, 155, 159, 160; increase 
of, with increase of money or bank 
deposits, 179-180; study of rise of, 
and effects, in a transition period, 
186-187; lowering of, after crest of 
credit cycle is passed, 189; remote 
influences that affect, such as geo- 
graphical differences, extent and 
variety of human wants, etc., 192 ff. ; 
effect of protective tariffs on, 194-195, 
207-208; influence on, of individual 
habits, systems of payments, density 
of population, and rapidity of trans- 
portation, 196-203; raising effect of 
improved monetary and banking 
facilities, 202 ; trusts, by issuing a 
great mass of stocks and bonds, tend 
to raise, 203 ; influence of international 
trade on, 204-209 ; influence of melting 
and minting on, 209-211; influence 
of production and consumption of 
money metals on, 21 1-2 14; use of, 
as an index number for indicating 
general trend of changes in prices, 249 ; 
the history of price levels, 253-257 ; 
effect of increase in production of 
gold on, since 1S96, 255 ; individual 
prices presuppose a, 258-259, 276—277 ; 
necessity for allowing for differences 
in, in comparing marginal desirabil- 
ities of money, 300; the real and the 
ideal adjustment of rate of interest 
to the rise or fall of, 361-362. 

Price of money, two meanings of phrase, 
358. 

Price of wealth, definition, 14; asking 
price and bidding price, 15-16; deter- 
mination of, by appraisal, 16. 

Prices, individual : the principles that 
determine, 144 ff. ; effect of supply 
and demand, or their underlying force, 
the purchasing power of money, 
on, 145-146 ; reciprocal relation 
between purchasing power of money 
and general level of, 146 {see Price 



level) ; do not move up or down in 
unison, 247-248 ; existence of con- 
tracts may retard adjustment of, 248 ; 
other restrictions on free movement 
of, 248-249; must therefore change 
relatively to each other, 249 ; general 
movement of, expressed by an index 
number, 249; the price level an 
average magnitude for indicating 
general trend of changes in, 249; 
explanation of how a price level is 
presupposed by, 258-259, 276-277; 
elimination of differences in, by com- 
petition, 260-261 ; relations between, 
and demand and supply, 261—263 ; as 
shown by demand and supply curves, 
263 ff. ; connection between desirabil- 
ity and, 282 ; fixing of, under monopoly, 
329—330; mutually related, 333 ff. ; 
leveling of, by arbitrage transactions, 
333-335 ; necessary injury to individ- 
uals from equalization of, 336-337; 
equalization of, as between different 
times, by speculation, 338-339; 
though directly fixed by supply and 
demand at a certain time and place, 
are indirectly affected by the supply 
and demand at other times and places, 
344-345 ; of goods which compete on 
the demand side, or substitutes, 344- 
347 ; sympathetic relations as to, 
between commodities and their sub- 
stitutes, 345-346 ; of goods which are 
complementary on the demand side, 
347-348; of goods in series, 3S0-351; 
in the last analysis depend on compari- 
sons between satisfactions or efforts, 
or both, 351-353; relation of rate of 
interest to, as the universal time-price, 
406-408; review and classification of 
influences on, 408-409; in case of 
land, follow the principles of substi- 
tutes or of competing articles, 414. 

Primary money, definition, 149. 

Production, three kinds of interactions 
included imder, 77-78; transforma- 
tion of wealth, 78-79 ; transportation 
of wealth, So ; exchange, or interactions 
which change the ownership of wealth, 
81 ; accounts illustrative of interac- 
tions in, 84-88. 

Productivity, measurement of wages of 
laborers as of rent of land by rate of, 
435-436. 



INDEX 



527 



Productivity theory of interest, 365-369. 

Profits, explanation of undivided, 41, 42 ; 
income in form .of, 424 ; elements of 
risk and variability in, 424-425 ; 
workmen whose wages come in form 
of, or employers, 454^455 ; comple- 
mentary and competitive relations 
between wages and, 456-457; reasons 
why usually high, in comparison with 
wages, 457-458. 

Property, or property right, definition, 
27, 28; the real basis underlying, 
is wealth or free persons, or both, 29 ; 
is the present right to the benefits 
of wealth, while wealth is the present 
means for securing future benefits, 
30-31 ; confusion as to certificates of 
ownership and real property rights to 
be avoided, 31-32; table illustrating 
existence of wealth behind property 
rights, 33 ; problems of, including 
double taxation, perpetual ownership, 
rights to bequeath, etc., 34-36. 

Protectionism, doctrine of, and fallacy 
associated with, 8. See Tariiis, pro- 
tective. 

Purchase and sale, nature of exchange 
called, 15. 

Purchasing power of money, the force 
underlying the supply and demand of 
all articles, 145-146; reciprocal rela- 
tion between price level and, 146 
{see Price level) ; causes which deter- 
mine, 151 f[. ; causes and effects of, 
during transition periods, 184 ff. 



Quantities of total instruments, property 
rights, and benefits, determination of, 
410 ff. 

Quantity, measurement of wealth in 
respect of, 17, 18, 19. 

Quantity of money, is only one of three 
factors in determining price level, 156 ; 
fallacy of theory of any relation be- 
tween rate of interest and, 356-359. 

Quantity theory, that price level varies 
directly as the quantity of money in 
circulation, 1 51-15 2, 160; elucidation 
of, by the equation of exchange, 152- 
156; illustrations of, 160-164; rests 
ultimately upon the fact that money 
has no definite relation to the satis- 



faction of wants but only the power 
to purchase things having such 
satisfying power, 164; proving the, 
242-247. 
Quick assets, definition, 49. 



R 



"Race suicide," conditions resulting in, 
475-476. 

Rae, John, remedy for the evils of vanity 
suggested by, 509-510. 

Railway company, illustrative income 
account of a, 71-72. 

Railways, velocity of circulation in- 
creased by, 201. 

Rapidity of turnover, method of deter- 
mining, 152-153; influence on, of 
habits, systems of payments, density 
of population, and rapidity of trans- 
portation, 196-203. 

Rate of impatience. See Impatience. 

Rate of interest, definition, 103-104 ; a 
means of translating present money- 
value into its eqmvalent future money- 
value, or vice versa, 105 ; avoidance of 
idea that money is the one and only 
source of, 106-107 > distinction be- 
tween interest and, 107 ; method of use 
for computing present from future 
values, 107 ff. ; in valuation of bonds, 
1 13-124; effect of changing, on value 
of capital, 125-126; process of deter- 
mining, 354 ff. ; definition of explicit 
and implicit, 354; quantity of money 
has no bearing on, 356-359; effect on, 
while inflation is taking place, 359-361 ; 
ideal adjustment of, to rising or falling 
prices, 361-362 ; avoidance of crises 
by adjustment of, 363 ; ways of 
securing better adjustment of, 363- 
364 ; shown to be the premium people 
are willing to pay for present enjoy- 
able income in terms of future enjoy- 
able income, 371-374; influence of 
differences in human nature on 
differences in, 375-378; summary of 
the six conditions which determine, 
400—403 ; examples of Holland, Scot- 
land, England, and France vs. China, 
India, Java, etc., cited to illustrate 
statements as to, 404-406 ; shown to 
be the universal time-price, by which 
income is capitaUzed and income 



528 



INDEX 



accounts formed, 406-408; depend- 
ence of wages upon, 442-443. 

Rate war, conditions resulting in a, 
317-321; how brought to an end, 323. 

Real estate, definition, 9 ; classification 
of, 10; the least exchangeable of 
commodities, 147. 

Real person, distinction between account- 
ing of fictitious person and, 40, 50^-51, 
95-98. 

Receipts and disbiusements, effect of 
customs regarding, on velocities of 
circulation, 199-201. 

Rent, definition, 412 ; attributes of 
explicit and implicit, 412-413; of 
land, 413 ff. ; similarity of wages and, 
433-436 ; tendency of land rent to 
rise, 461. 

Rent-purchase, device to circumvent 
prohibition of usury, 397. 

Reserve, cash, in banking, 176-178. 
See Bank reserves. 

Ricardian doctrine of the "marginal 
acre," 413-418. 

Rights to benefits of wealth, 26-30. 

Risk, element of, to be considered in 
determining capital-value, 138-140; 
influence of, on rate of interest, 383- 
385 ; element of, in dividends and 
profits forms of income from capital, 
424-425 ; stockholders' assumption 
of, 425—426; implies a larger though 
more fluctuating income, 426; methods 
of avoidance of, by increasing knowl- 
edge of the future, by employing 
safeguards against mischances, by 
insurance, and by hedging, 427-432; 
the undertaking of, distinguishes em- 
ployers from employees, 455 ; enter- 
priser-capitalists who assume, are called 
"captains of industry," 459-460. 

Running costs, 323-324; at bottom are 
similar to fixed costs, 326; division 
into general costs and particular 
costs, 326—327. 

Runs on banks, 187-188. 



Sacrificed desirability, 296. 

Safety devices, as a means of reducing 

risk, 428. 
Salaries, no real distinction between 

wages and, 433 n. 



Sale, method of, for modifying income- 
stream or equalizing marginal rates 
of impatience, 394-396; loans viewed 
as sales, 394-395 ; a means of cir- 
cumventing prohibitions of interest, 
396-397- 

Satisfactions, or consumption, form the 
ultimate, uncanceled item of the 
income account, 77, 98-99, 142, 307, 
351-353- 

Savings, or appreciation, 134-135 ; effect 
of, on wages and hours of workingmen, 
438. 

Schedules of demand and supply, 261- 
263, 303-306. 

Scotch and Irish compared as to im- 
patience and therefore as to rate of 
interest, 376. 

Sea-water gold, 256. 

Seigniorage, definition, 162-163, 210. 

Self-control, and rate of interest, 376; 
countries which lack, and where high 
interest rates prevail, 404. 

"Selling short," operation known as, 
339-341 ; as a device for reducing 
risk, 430-432. 

Series, prices of goods in, 350-351. 

Services, definition, 23. 

Silver, is fiduciary money, 149. See 
Bimetallism. 

Single-tax theory, 413. 

Slaves considered as wealth, 10. 

Slow assets, definition, 49. 

Socialism, question of, in solution of 
economic problems, 35-36 ; theory of 
interest according to, 369-371. 

Social racing, 500-511. 

Sociology, economics a branch of, 514. 

South America , efiect on trade of lack of 
business confidence illustrated by, 195. 

Space, measurement of wealth by, 11-12. 

Speculation, function of, to equalize 
prices as between different times, 
338-339; two chief kinds of, as 
represented by operations of "bulls" 
and "bears," 339; "selling short," 
339-341 ; limitations on profit from, 
341-342 ; item of interest to be consid- 
ered in, 342 ; uncertainty of, may lead 
to aggravation of inequality of prices 
instead of equaUzing them, 342-343' 
unwise and injudicious character ' 
much, 343-344 ; so far as speculatit 
is good, it tends to equalize prices ix 



INDEX 



529 



time, 344; employment of, to reduce 
risk, 430-432. 

Spending, equalization of rates of impa- 
tience by, 304-396; definition of, 
395 ; antithesis between investing and, 
395-396. 

Standard gold, definition, 11. 

Standardization, of income, 67-69, 136— 
138 ; land not capable of, 414. 

Statutes of mortmain, 492. 

Stock dividend, issue of stock called, 43. 

Stockholders, in joint stock company, 
41 ; of banks, 174; risk of investment 
of, contrasted with comparative safety 
of bondholders, 425-426; assumption 
of risk by, implies a larger though 
more fluctuating income, 426; rela- 
tion between employers and wage- 
earners analogous to that between 
stockholders and bondholders, 455, 
457- _ 

Stock jobbing, explanation of, 46—47. 

Stock of goods, definition, 37; capital 
consists of a, 38. 

Stock watering, 46-47. 

Substitutes on the demand side, defini- 
tion, 345 ; influence of prices of, on 
commodities themselves, 345-347 ; 
sympathetic relations existent among 
prices of fuel, food, clothing, etc., 
substitutes, 346; substitutes on the 
supply side, definition, 349-350; 
prices of land follow the principle of, 
414. 

Sunk cost, 324. 

Supply, schedule of, 262-263, 303-306 ; 
relations between demand and, 
represented by curves, 263 ff., 303- 
306; shifting of, 268-277; the 
influences behind, 303 ff. ; marginal 
undesirabiHty or cost to be considered 
in connection with, 305 ; cases where 
rise of price results in reduced, 313- 
314; conditions of, which result in a 
rate war or "cutthroat competition," 
314—321 ; tendency toward monopoly 
resvilting from competition in, 321- 
322; fixed and running costs in con- 
nection with, 323-326; found to rest 
in the ultimate analysis on efforts, 
351-353. 

Supply and demand, discussion of the 
phrase, 144-145 ; concealed reference 
to the purchasing power of money 
2 M 



implied by, 260; the ultimate factors 

of, are efforts and satisfactions, 351— 

353- 
Supply at a given price, meaning of term, 

261—262. 
Supply curve, definition, 265. 
Supply schedule, definition, 262. 
Surplus, definition, 41; balance sheets 

to illustrate, 42. 
Surplus desirability, 295-296, 297-298. 
Switzerland, large per capita wealth of, 

470. 
Systems of payments, influence of, on 

velocity of circulation and therefore 

on prices, 199-201. 



Tariffs, protective, effect of, on volume 
of trade and on prices, 194-195 ; effect 
on quantity of money and on prices, 
207-208; an interference with the 
equalization of prices, 336 ; analogy 
between, and the movement against 
labor-saving machinery, 337; in one 
aspect an offspring of the make-work 
fallacy, 453-454. 

Taxation, double, 34; solutions of 
difliculty of double, 57-58. 

Telegraph, velocity of circulation of 
deposits increased by the, 201-202. 

Thrift, dependence of a nation's accumu- 
lated products on quality of, 469; 
role played by, in the distribution of 
wealth, 480-481. 

Time, influence of, as concerns income- 
stream, on impatience and the rate of 
interest, 379-381. 

Tobacco as money, 147, 149. 

Total desirability, 283-285. 

Trade, a gain should result to both sides 
in a, 297. See Volume of trade. 

Trade journals, function of, to increase 
knowledge of the future and thus 
reduce risk, 427. 

Trade schools, increasing efficiency of 
labor by, 448-449. 

Trade-unions and rate of wages, 444. 

Transfer of wealth, definition, 14; one- 
sided and reciprocal, 14 ; is an inter- 
action which changes the ownership 
of wealth, 81. 

Transformation of wealth, the, 77-78; 
various stages of, to be viewed as 



530 



INDEX 



costs or benefits and debited or 
credited accordingly, 78-79. 

Transition periods, causes and effects 
of purchasing power of money during, 
184-191 ; rate of interest and its 
adjustment during, 359-362. 

Transportation, definition, 80; effect of 
facilities for, on conditions affecting 
trade, 193, 194; influence of rapidity 
of, on velocities of circulation and on 
prices, 201-202 ; effect of cheap and 
rapid, on equalization of prices, 33S- 

337- 
Trusts, issue of stocks and bonds by, 

tends to raise price level, 203 ; growth 

of, due to necessity of protection 

against competition, 331. 
Turnover. See Rapidity of turnover 

and Velocity of circulation. 



U 



Uncertainty of income, influence of, on 
impatience and the rate of interest, 
383-385 ; relative positions of bond- 
holders and stockholders as to, 424- 
427; reduction of, by increasing 
knowledge of the future, by employing 
safeguards against mischances, by 
insurance, and by hedging, 427-432. 

Undesirabihty, marginal. See Marginal 
cost. 

Undivided profits, definition, 41, 42. 

Unearned increment, increase in land 
value due to no labor on owner's 
part called, 418-419; usually a case 
of luck, 481. 

Units of measurement, accuracy of, 20-21. 

Uses, benefits rendered by things, 23. 

Utility, quality of, implied in ownership, 
3 n. See Desirability. 



V 



Value, definition, 17 ; money as a measure 
of, 18-19 ; risk in measuring amount of 
wealth by, 18-19 ; difficulties of finding 
right way for measuring value of 
wealth, 19-20. 

Values, book and market, 44-45. 

Vanity, a motive for socially injurious 
rivalry, 502-506; size of tax laid by 
society upon itself owing to, 506-508 ; 
remedies for evils of, in the way of 



"social disarmament," compulsion by 
government, inducing fashion to run 
in more useful channels, etc., 508-511. 

VariabiHty, element of, in dividends and 
profits forms of income, 424-425. 

Variations of income in relation to 
capital, 127 ff.; effects of interest ac- 
crued and interest taken out, 127-132 ; 
appreciation and depreciation, 134- 
136; offsetting variations, by depre- 
ciation fund and other devices, 136- 
138; the risk element, or chance, 138- 
139- 

Variety of himian wants, effect of, on 
volume of trade and prices, 192, 194. 

Velocity of circulation, definition, 151; 
how determined, 152-153; influence 
on, of individual habits, systems of 
payments, density of popvJation, and 
rapidity of transportation, 196-203 ; 
an increase of money shown not to 
decrease, 242-247. 

Vitality, increasing efficiency of laborers 
by improvement in physical and 
mental, 446-448. 

Volmne of trade, influences which affect, 
in the way of various conditions affect- 
ing producers and consumers, 192 ff. ; 
as an average magnitude for indicating 
general tr2nd of changes in quantities, 
249-253. 

W 

Wages, raising of, by a protective tariff, 
208, 453-454; necessity of correcting, 
in comparisons of, for differences in 
price levels, 300 ; cases where a rise in, 
results in decreased supply, 313-314. 
436-438; competition of costs illus- 
trated by tendency of, to keep pace 
with each other, 348-349; defined 
as the income from labor, 433 ; exphcit 
and implicit, 433 ; rate of, dependent 
on the laborer's productivity, 435 ; pe- 
culiarities of labor supply and, 436 ff. ; 
reduction in, means wiUingness to 
work longer hours, 438; are seldom 
discounted in order to ascertain 
laborer's capital-value and so seldom 
regarded in Ught of interest on his 
capital-value, 438-439; are always 
reckoned as gross and never as net, 
439; differences between supply of 



INDEX 



531 



wage-earners and that of other instru- 
ments, 439-440; discussion of, from 
the employer's viewpoint, 440 ff. ; 
a marginal unit of work as a barometer 
of, 441 ; are the discounted value of 
the future benefits the employer 
receives, and are dependent upon the 
rate of interest, 441-442; effect of 
trusts and trade-unions on, 444; 
both competitive and complementary 
relations between profits and, 456-457 ; 
in general, profits are much higher 
than, 457-458. 

Wants, effect of extent and variety of, 
on conditions affecting trade, 194; 
the real foundation of demand, 300- 
302. 

War and preparation for, economic 
waste represented by, 501. 

Wealth, broad and narrow definitions of, 
3 ; significance of, in common parlance 
and in economic usage, 4 ; distinction 
between money and, 5-9; classifica- 
tion of, into real estate and commodi- 
ties and their subdivisions, 9-1 1; 
measurement of, 11 ff.; attribute of 
materiality, providing a basis for 
measurement by weight, space, and 
niunber, 11-12; necessity of homo- 
geneity of, in measuring, 12; attri- 
butes of, not to be regarded as separate 
and independent kinds of, 13 ; transfer 
of, is a change of ownership, 14; ex- 
change of, a pair of mutual and volun- 
tary transfers, 14; price of, defined, 
14—15 ; money means wealth generally 
acceptable in exchange, 15; value 
of a given quantity of, defined, 17-20; 
limit of accuracy in measurements of, 
20-22; the benefits of, 23-25; the 
costs of, 25-26; property rights to 
enjoy benefits of, 26-27; to be re- 
garded as the present means for 
securing future benefits, 30-31 ; cor- 
respondence between property rights 
and, 31 ; table illustrating existence 
of, behind property rights, 33; con- 
ception of capital and income relative 



to, 38; value and distribution of, in 
America, 59 ; deposit banking a device 
for facilitating circulation of, 165-171; 
the concrete, tangible wealth of the 
world which forms the basis of circulat- 
ing credit, 1 71-174; problems of 
poverty and, 464 ff . ; the distribution 
of, 465 ff . ; consideration of the wealth 
of nations, and on what it depends,' 
467-469; per capita wealth, 469 ff. ; 
increase of national, and increase or 
decrease of per capita, depend on ratio 
between population and, 470-472 ; 
view of, as a means of attaining social 
position leads to decrease in birth rate 
among the wealthy, 475-476; in- 
equalities in distribution of, among 
individuals, 476-478; upper limit 
to the growth of individual, 484- 
486; the cycle of, 487-489; laws 
and customs as to inheritance of, and 
effect on distribution, 491-493 ; the 
true worth of, as compared with the 
market worth, 494-497 ; dangers and 
evils connected with possession of 
extreme, 495-497; forms of, which 
injure the owner, 498-499; forms of, 
injurious to society as a whole, 499- 
500; forms of, used for social rivalry, 
of which examples are warfare and 
preparations for war, cutthroat com- 
petition, and rivalry in wealth itself 
to gratify vanity, 500-506. 

Weight, measiu-ement of wealth by, 11; 
the povmd sterUng and the dollar as 
units of, II. 

White-slave traffic, causes of, traced 
to imequal distribution of wealth, 
496-497- 

Wills, laws regarding and examples of 
curious, 491-493. 

Work, benefits rendered by free human 
beings are called, 23. 

Working hours, increase in wages means 
decrease in, 313-314, 436-438; reduc- 
tion of, increases efficiency of labor, 
447-448. 

Workingmen. See Laborers. 



npHE following pages contain advertisements of 
books by the same author or on kindred subjects 



WORKS BY IRVING FISHER 



The Rate or interest 

Its Nature, Determination, and Relation to Economic Phenomena 

Cloth, 8vo, 442 pages, Index, $3.00 net; by mail, $3.20 

Editorial in Moody'' s Magazine, January, 1908: 

"... It contains some conclusions of great value to financiers, banlc- 
ers, underwriters, etc. — knowledge that put millions of dollars into the 
pockets of some who possessed it and the lack of which cost others 
(bond houses, for instance) more millions. It may be said, in passing, 
that this recent book is easily not only the most complete, but the most 
valuable treatise in the English language on the very important, but lit- 
tle understood, subject of interest rates. In fact it is, perhaps, both the 
latest and most scientific discussion of this subject in any language. . . ." 

The Nature of Capital and Income 

Cloth, 8vo, 427 pages, $3.00 net; by mail, $3.20 

Marcus C. Knowlton, Chief Justice of Massachusetts : 

" A great book, and analytical, logical, and philosophic in a high de- 
gree. The definitions and statement impressed me as accurate as well 
as clear, and the reasoning is easily followed. It seems to me logically 
impregnable." 

Umberto Ricci in a 21-page review, "Rassegna del Movimento Scien- 
tifico," in Giornale Degli Economisti, September, 1907 : 
" Professor Irving Fisher has published a recent volume on ' The Na- 
ture of Capital and Income,' which deserves to be considered and dis- 
cussed at length. . . . The author is an economist who bridges the gap 
between his science and the theory of bookkeeping. . . . This book of 
the able American economist, because of the coherence of his method, 
the clearness and symmetry of his exposition and the acute and inge- 
nious applications which he makes, deserves a notable place in the 
recent literature of our science." 

A Brief Introduction to the Infinitesimal Calculus 

Revised Edition. Cloth, i2mo, 84 pages, $.75 net; by mail, $.80 

Journal of Education : 

"This little volume is designed especially to aid in reading mathe- 
matical economics and statistics. It is also equally adapted to the use 
of those who wish a short course in ' The Calculus,' as a matter of gen- 
eral education. // is admirably adapted to its purpose in either case.'''' 



PUBLISHED BY 

THE MACMILLAN COMPANY 

64-66 Fifth Avenue, New York 



The 

Purchasing Power of Money 

By IRVING FISHER 

Cloth d'vo $3,00 net 

ALTHOUGH THE PURCHASING POWER OF MONEY 
• has been published only a few weeks, economists and 
scholars of authority have freely declared that it is by far the 
most important work yet published on that special phase of 
economics with which it is concerned. In fact, some of them 
go so far as to say that it is the most important work in the 
whole field of economics. The following extracts taken from 
the Manchester Guardian of England, The Herald of Glasgow, 
Scotland, The New York Sun, The Chicago Journal, and Moody's 
Magazine will serve as a general index of the character of the 
many favorable articles which have been written about the book. 

The Manchester Guardian heads its article by Prof. S. J. 
Chapman, of Manchester University, with the phrase "A^ 
Masterpiece in Economics," and says in part: "Professor 
Irving Fisher is to be congratulated on having successfully car- 
ried through the most brilliant piece of economic investigation 
which has been done for some years. ... He has solved the 
problem which economists have commonly held to be insoluble. 
The problem is to deduce from the known facts of the currency 
the purchasing power of money." 

Of the author's fitness to write upon this subject The Glas- 
gow Herald comments: "Few economists and statisticians are 
so well qualified for such an undertaking as Professor Fisher, of 
Yale University, whose earlier books on ' The Nature of Capital 
and Income ' and ' The Rate of Interest ' stamped him as one 
of the ablest statistical economists living." 



The New York Sun is most impressed, it would seem, by the 
practical quality of the work. This paper writes: "A notably 
original and suggestive study of the causes which bring about 
periodic changes in the level of prices is contained in 'The 
Purchasing Power of Money' (Macmillan's), by Professor 
Irving Fisher of Yale University. The author, whose contribu- 
tions toward the development of the modern theory of value 
are known to economists the world over, applies this theory in 
the present volume to the solution of the problem of finding a 
remedy for crises and trade depressions." 



The Chicago Journal appreciates that one of the unique and 
most valuable characteristics of the work lies in its determina- 
tion of the velocity of circulation of money. " For the first time 
in history the velocity of circulation of money has been statis- 
tically determined by means of a method original with the 
author. . . ." 



And finally Moody's Magazine, well known as a financial 
authority, writes of the author and the book as follows: "Pro- 
fessor Irving Fisher is not an ordinary economic writer; he 
stands high as a mathematician, sociologist, and scientist. He 
has a keenly analytical, logical, and philosophical mind. . . . 
His recent works on ' The Rate of Interest ' and ' The Nature 
of Capital and Income ' are undoubtedly the most scientific and 
valuable economic works in the English language. 

"■'The Purchasing Power of Money' is really the third 
volume of Professor Fisher's economic works — omitting his 
recently published 'Elements of Economic Science,' which 
is intended as a text-book. While the discussions in both 
'The Rate of Interest' and 'The Purchasing Power of 
Money ' are highly scientific, theoretical, and academic, they 
are also eminently practical and extremely important to all men 
of affairs. . . ." 



Journal of the Royal Statistical Society, Vol. LXXIV, 

Part VII, June, 1911. (Prof. S. J. Chapman, Manchester University.) 

" The kernel of this book contains the results of a brilliant piece of 
research, in which, after discussion of the theory of the value of money, 
an attempt is made to establish the truth of the quantity theory 
inductively. 

" In the opinion of the reviewer, this book is a magnificent achieve- 
ment. . . . The research of which a brief account has been given in 
this notice wiU add greatly to the renown which its author has already 
fully earned by his two volimies on ' Capital ' and ' Interest ' respec- 
tively, and by his report to the American Senate on the conservation 
of vital forces." 

The Economic Journal, No. 83, 

Vol. XXI, September, 191 1. (J. M. Keynes.) 

" Professor Fisher's book is marked, as all his books are, by extreme 
lucidity and brilliance of statement. It is original, suggestive, and, 
on the whole, accurate ; and it supplies a better exposition of monetary 
theory than is available elsewhere." 

Quarterly Publications of the American Statistical Association, 
Vol. XII, December, 191 1. (Warren M. Parsons, Dartmouth College.) 
" ' The Purchasing Power of Money ' is a notable achieve- 
ment. ... In the opinion of the reviewer Professor Fisher's book 
takes its rank as the premier treatise on the theory of money." 

The Quarterly Journal of Economics, 

Vol. XXVI, November, 1911. (O. M. W. Sprague, Harvard.) 

" The prediction may be ventured that the book will become a classic 
in the literature of money, and that it will also prove a starting-point 
for fruitful investigation in the future." 

Journal of the American Economic Association, 

Fourth Series, No. 5, September, 1911. (David Kinley.) 

"... and may fairly be called, on the whole, the most important 
American book of the year in the field of economics." 

The Economist, London, England, 

January 6, 1912. 

"As very little of an authoritative nature has been written in this 
coimtry on this question, outside the covers of formidable Blue Books, 
Professor Fisher's book should be widely read, especially since the gen- 
eral level of prices seems to be rising, and the public is once more be- 
coming concerned in the conditions which determine the purchasing 
power of money." 



The Economist, London, England, 
January 6, 191 2. Supplement. 

" It is one of the most important books of the year on economic 
theory. . . ." 

Westminster Gazette, London, England, 
November 25, 191 1. 

" To the economist, to the general reader, most of all, perhaps, to the 
lecturer and the student we can recommend the book very warmly." 

Canadian Finance, Vol. Ill, No. 3, 
Feb. 7, 191 2. 

" To investors, and business men generally, its chapters will be foimd 
to contain matter of very direct and practical bearing." 

Moody^s Magazine, October, 191 1, 
New York City. 

"His suggestion of a new and more stable standard of value is so 
important, though he says that years of education of the public must 
precede any attempt to put it into practice, that we have obtained 
permission of the Macmillan Company, publishers of the book, to 
present here an abstract of the professor's proposal. 
" Probably no modern writer has studied this question more deeply 
than Professor Fisher, and his suggestion of a new standard of value 
deserves the careful thought of every banker, investor, and business man." 

Weekly Barometer Letter afid Composite Plot 

Compiling Offices of Babson's Statistical Organization, 

Wellesley Hills, Mass., March 13, 191 1. (Roger W. Babson.) 

"... certainly this work of Professor Fisher's will be of great aid to 
such bankers, merchants, and investors as are now studying fimdamen- 
tal conditions." 

Trend, 

New York City, June, 191 1. (Frank Hendrick.) 

" It is the vigorous expression of a keen intellect ; its straightforward- 
ness and its definite purpose mark it as distinctly unacademic. 
This book is challenging, informing, and guiding. It shows the way 
and defines the issue." 

The Public, 

No. 693, Vol. XIV, July 14, 191 2. (William Howe Crane.) 

" Professor Fisher's book should be read by every one who is interested 
in monetary problems. It lays upon secure foundations certain essen- 
tial principles, which can never hereafter be reasonably questioned. 
It is a very valuable contribution to the new political science, whose 
teachings are not to be colored through social or political prejudice." 



Engineering Literature, ' 

November i6, 191 1. 

" The volume before us sheds abundant light on what is to most every 
one a mysterious subject." 

John Perrin, Chairman of the Board, 

The Fletcher American National Bank of Indianapolis, Ind. 

" Your work appears to me a most extraordinary one. The book is 
absorbingly interesting, and the lucidity, cogency, and accuracy of its 
reasoning could hardly fail to carry conviction in an unusual degree." 

American, Philadelphia, Pa., 
June 10, 191 1. 

" An important study in financial economics is Professor Irving 
Fisher's 'The Purchasing Power of Money.' . . . 
"For the first time in history the velocity of circulation of money has been 
statistically determined by means of a method original with the author." 

Statesman, May 7, 191 1, 
Boise, Idaho. 

"... there is much of value and illumination in this well-reasoned 
scientific yet readable work." 

Leader, June 9, 191 1, 
Cleveland, Ohio. 

" The ' Purchasing Power of Money,' by Irving Fisher, professor of 
political economy at Yale, is suggestive of a threadbare topic, but it is 
anything but that. The volume of 500 pages is a refreshing study and 
reconstruction of the ' quantity theory.' " 

Nation, November 30, 1911, 
New York City. 

" Few persons are more successful than Professor Fisher in putting old 
wine into new bottles. He has taken the most hotly debated of all 
economic questions, and by the use of arguments long familiar to 
special students, has produced an imposing work." 

Times, January 7, 191 2, 
New York City. 

" It is timely to recall the views expressed by the professor in his new 
book, * The Purchasing Power of Money,' which has two marked char- 
acteristics. Firstly, it gives a precision never before attained or at- 
tempted regarding the effect of the quantity of money in circulation 
upon prices, either in raising or lowering them. Secondly, it proposes 
a remedy which is both in accord with the principles of classical econ- 
omists, and which is yet progressive enough to satisfy the most ad- 
vanced thought of this progressive age." 



SD 326 



Religious Telescope, May 24, 191 1, 
Dayton, Ohio. 

" The author has presented a fine argument in support of his views, 
and discusses the whole question of the title with much fitness and 
accuracy. It is a valuable book, with maps and tables illustrating the 
facts and figures submitted." 

Philip B. Kennedy, Instructor in Economics at the Boston Y. M. C. A. 

School of Commerce and Finance. 

"Professor Fisher has distinguished himself in many ways, but his 
work, ' The Purchasing Power of Money,' stamps him as unquestionably 
one of the ablest students of practical economics that we have to-day." 

Post, January 4, 191 2, 
Boston, Mass. 

" Epoch-making book." 

Evening Transcript, April 24, 1911, 
Boston, Mass. 

" Certainly no student or reader in the field of economics can afford to 
pass it by unread." 

Yale Review, April, 19 12, 

New Haven, Conn. (E. W. Kemmerer, Cornell University.) 

" This book is one of the most important contributions to monetary 

science ever made by an American scholar." 

American, October 28, 1911, 
Waterbury, Conn. 

" This book, whose main purpose is a re-examination and revision of 
the old ' quantity theory ' of money, has attracted wide attention 
among economists of authority, some of whom go so far as to say that it 
is the most important work recently published in the field of economics." 

Tribune, November 5, 1911, 

Los Angeles, Cal. 

"Irving Fisher is recognized as one of the greatest living authorities 
on financial and economic subjects. His latest work will attract 
world-wide attention, not only by reason of the fame of the author, 
but because of the vital importance of the problem and the great 
value of the subject matter." 



THE MACMILLAN COMPANY 

Publishora 64-66 Fifth Avenue New York 



JUL 5'W12 



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